The old saying goes, “The only things certain in life are death and taxes.” You likely paid them during your working years and may continue paying them on income you receive in retirement. As a retiree, your taxes won’t necessarily get simpler. You will likely face new and different complexities, so you may benefit from trying to estimate your potential federal and state taxes in retirement. Your income and taxable events may change substantially in retirement. And various types of income are taxed differently. Understanding these differences can help you make sense of a few key tradeoffs and help you plan for your retirement years.
Keep in mind the contents of this document shouldn’t be construed as tax advice. If you have questions regarding your personal tax situation, please contact your tax professional.
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, we’ll consider some of these different income sources and how they are generally taxed.
Social Security. Unless Social Security is your only income source in retirement, you may have to pay income taxes on your Social Security benefits. This depends on how much additional income you receive besides Social Security income. This 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.[i]
When you start taking Social Security benefits can also impact your benefit amount and your tax bill.
IRA distributions. Starting at age 59½, you can take penalty-free distributions from your individual retirement accounts (IRAs). Prior to 59½, you may be charged a 10% penalty on early withdrawals. Distributions from a traditional—tax-deferred—IRA are normally subject to ordinary income taxes. Distributions from a Roth IRA are tax-free since you already paid taxes on that money prior to contributing it. Taking distributions from a traditional IRA isn’t mandatory until the year following the year you turn age 70½, at which point you must take required minimum distributions (RMDS). Roth IRAs normally aren’t subject to RMDs.
The IRS has specific rules on how much your annual RMD should be. In general, the amount is calculated using a formula involving your current age and the value of your IRA.
401(k) distributions. You can generally start taking penalty-free distributions from your 401(k) retirement plan at age 59½. Distributions from 401(k) accounts are generally included in your taxable income except for qualified distributions from Roth 401(k) accounts.[ii]
As with IRAs, starting the year following the year you turn age 70½, you may need to take RMDs from your 401(k). See the specific IRS rules to estimate the potential RMD for your 401(k) plans. Many people roll over their 401(k) plans into IRAs after they retire. One potential upside is that an IRA may offer more investment choices some 401(k) plans, which can limit your investment options to the funds offered by your company plan. However, it’s important to note that investment options can vary between 401(k) plans.
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:
Annuities. Tax treatment for annuities depends on the type of annuity. If you buy an annuity through a tax-deferred retirement account, like an Individual Retirement Account (IRA) or a 401(k), you’ll pay regular income taxes on the ongoing annuity payments. But if you buy in a Roth IRA, you have likely already paid taxes on those funds and you may not need to pay taxes once those ongoing payments begin.
If you buy an annuity in a taxable account, the earnings from your annuity get taxed, but your initial investment (also known as your “basis”) does not. This is similar to a capital gains tax, in that you generally just pay taxes on the amount your investment earns. The difference is that with annuities you may have to pay at ordinary income tax rates instead of capital gains tax rates.
For more information, our article Annuity Taxation along with other supporting articles on our website may be helpful.
There is no perfect solution when deciding how taxes should affect your retirement account withdrawals. As a retiree, you will have to determine which tradeoffs will balance your short-term needs with your long-term investing goals. Careful planning can help ensure that there are no surprises on your tax bill.
Dividends vs. long-term capital gains. Dividends may be appealing since they seem to offer regular ongoing income. However, when the stocks are falling, some companies may cut or stop paying their dividend in the short run. So if you rely on dividends alone for ongoing income, you could potentially run short of cash in tough times.[iv]
Dividends are a way for a company to pay profits to shareholders. Because the company is regularly giving cash to its shareholders, dividend-issuing stocks may have less price appreciation over time. If you focus solely on dividends, it may also narrow your investment options or force you to be overweight in certain sectors or areas of the market that may not be in your best interest.
Homegrown dividends. One option you may have is the strategy of selectively selling 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.
Tax loss harvesting. If you sell assets that have greatly appreciated in value, you may have to pay significant 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 potential to take advantage of this option. Conversely, investors normally can’t just sell individual securities within a mutual fund or exchange-traded fund (ETF) to offset the gains.
Balancing taxable income with deductions. Consider how to best balance your distributions and other taxable events with deductions and capital losses. If you are in a position where you have to start taking RMDs and don’t necessarily need the money for living expenses, you may have a few options to reduce your tax burden:
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.
Navigating the many tax considerations leading up to and during retirement can be daunting. You will likely have to consider several factors such as your income, tax rate, 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 with your retirement 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 more.
The contents of this article shouldn’t be construed as tax advice. Please contact your tax professional.
[i] Source: Social Security Administration, as of 1/18/2019. https://www.ssa.gov/planners/taxes.html.
[ii] Source: Internal Revenue Service, as of 1/18/2019. https://www.irs.gov/retirement-plans/401k-plans.
[iii] Source: Internal Revenue Service, as of 1/18/2019. https://www.irs.gov/taxtopics/tc404.
[iv] Source: Internal Revenue Service, as of 1/18/2019. https://www.irs.gov/publications/p550#en_US_2017_publink100010086.