The following information should not be construed as tax advice. Please contact your tax professional if you have questions regarding your personal tax situation.
Taxes on Retirement Income
Benjamin Franklin once said, “In this world nothing can be said to be certain, death and taxes.” You likely paid taxes during your working years and may continue paying them during retirement—although the types and amount of taxes on your retirement income may be different than when you were working.
As a retiree, your tax situation may change but won’t necessarily get simpler. You will likely face new complexities, so you may benefit from estimating your potential taxes on retirement income. Understanding these differences can help you make sense of a few key tradeoffs and help you plan for your retirement years.
Types of Retirement Income and Their Tax Implications
In retirement, you should consider all potential income sources, such as dividends, bond coupon payments, proceeds from the sale of securities, Social Security income, pension income, annuity payouts or retirement account withdrawals. Here are some common income sources and their typical tax treatment.
When you start receiving Social Security benefits, you may have to pay taxes on that income. This depends on how much additional income you receive besides Social Security.
Additional income could come from pensions, retirement plan withdrawals or other retirement income sources.
The Social Security Administration’s website offers detailed information for calculating what percentage of your benefit is taxable each year.1
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Starting at age 59.5, you can take penalty-free distributions from your individual retirement account (IRA). Prior to 59.5, you may be charged a 10% penalty on withdrawals. Distributions from a traditional IRA are normally subject to ordinary income taxes. Distributions from a Roth IRA are tax-free since because you already paid taxes on that money prior to contributing.
Taking distributions from a traditional IRA isn’t typically mandatory until you turn age 72, at which point you must take required minimum distributions (RMDs). Roth IRAs normally aren’t subject to RMDs.
The IRS has specific rules the size of your annual RMD. In general, the amount is calculated using a formula involving your current age and the value of your IRA as of December 31st of the prior year. You should visit the IRS website for full details2.
In most cases you can start taking penalty-free distributions from your 401(k) retirement plan at age 59.5 Distributions from 401(k) accounts are generally included in your taxable income except for qualified distributions from Roth 401(k) accounts.3
As with IRAs, you may be required to take RMDs from your 401(k) starting the year you turn age 72. See the specific IRS rules to estimate the potential RMD for your 401(k) plans4.
Taxable Account Distributions
For investments in a taxable account, you may have to pay taxes on distributions or realized gains. Some common examples include the following:
- Dividends: Dividends are distributions made by corporations to their shareholders. Dividends can be ordinary or qualified. Ordinary dividends are typically taxed at regular income tax rates. Qualified dividends may be taxed at capital gains tax rates, which can sometimes be lower than the income tax rates.5
- Capital Gains: If you sell a stock for a profit, you may need to pay capital gains tax on those profits. If you held the stock for a year or less, that profit is generally treated as a short-term capital gain and will be taxed at your top marginal tax rate. If you held for more than a year, the profits will generally be taxed at the typically lower long-term capital gains tax rate. For higher earners, you may be subject to Net Investment Income Tax depending on your situation.6 Note that these taxes are not applicable to holdings in pre-tax IRA or after-tax Roth IRA accounts.
- Bond interest payments. Bonds, both corporate and Treasuries, commonly pay interest payments twice per year. Payments are typically taxed as ordinary income. Municipal bonds are typically exempt from federal income tax and, depending on the issuer, may be exempt from state and local income .
- Certificates of Deposit (CDs) interest payments. CDs typically accrue interest either monthly or quarterly with interest deposited in your account. This is taxed as ordinary income at the time the interest is received, not when the CD matures.
Tax Tradeoffs in Retirement
There is no perfect solution when considering taxes on retirement income. As a retiree, you will have to determine how to balance your short-term needs with your long-term investing goals. Careful planning can help reduce the surprises on your tax bill.
Dividends vs. Long-Term Capital Gains
Dividends are one way for a company to pay profits to shareholders. Dividends may be appealing since they seem to offer regular income. However, dividends aren’t guaranteed. For many reasons a company may cut or stop paying their dividend. So if you rely on dividends alone for income, you could potentially run short of cash in tough times.7
Another option for retirement income is to selectively sell stocks on an incremental basis for cash flow—or what we call “homegrown dividends.” While investors can incur trading commissions through this strategy, it is a flexible and potentially tax-efficient way to generate cash flow in a taxable account, especially for investors with larger portfolios.
If you sell assets that have appreciated in value over time, you may have to pay capital gains taxes. You may be able to offset those capital gains by selling assets that have lost value. We refer to this practice as tax-loss harvesting, and it can be an efficient strategy for assets in a taxable account.
Owning individual securities may give you more flexibility to take advantage of this option compared with a mutual fund or exchange-traded fund (ETF) to offset the gains.
Balancing Taxable Income with Deductions
Another consideration for your taxes on retirement income is how to best balance your distributions and other taxable events with tax deductions and capital losses.
For example, if you must start taking RMDs yet don’t need the money for living expenses, you may have a few options to reduce your tax burden:
- You could make charitable donations and take approved deductions to offset the increase in your taxable income from the RMD.
- You can reinvest your RMD by moving stocks, bonds, funds and other holdings directly into taxable investment accounts. The value of these securities when they are transferred counts toward the RMD and will be taxed accordingly. However, in this method, you may be able to stay invested and avoid additional transaction costs. This requires you to have cash available to pay the associated taxes.
And these are just a couple possibilities. In working with your tax professional, you may be able to explore other options to lessen your tax burden in retirement.
Need Help Planning for Taxes in Retirement?
Navigating the many tax considerations leading up to and during retirement can be challenging. There are several factors to consider such as your income sources, tax rates, expenses and potential tax liability—all of which can get complicated. Doing all this while maintaining a well-diversified investment portfolio can be downright exhausting.
Fisher Investments has helped investors with simple tax situations as well as those with more complex situations. We can help you determine potential taxes on retirement income and other planning needs before and during retirement. Contact us today to speak one of our qualified professionals or download one of our educational guides to learn .