There is one commonality that everyone shares in retirement – a price tag. Your price tag may be different from your neighbors’ or your friends’, but we all have one. That price tag or cost will depend on your goals and the lifestyle you desire to have in retirement. It also factors in housing, utilities, health care expenses, inflation, taxes and other expenses.
Building a healthy nest egg to live off of in retirement is probably one of the biggest challenges you may face, especially when you have competing priorities.
Identifying the sources of income that you can depend on is one of the first tasks in evaluating your retirement landscape. The bulk of retirement income for most people will come from personal savings and investments, Social Security and for some, earnings from continued employment. Examples of personal savings and investments include employer-sponsored retirement plans, individual retirement accounts (IRAs) and annuities, as well as individual stocks, bonds and mutual funds.
Different tax rules apply to each of these income sources. However, there are a variety of tax-advantaged strategies available to help you minimize your tax costs. Having said that, it’s important to recognize that the best solution for you will be based on your specific circumstances. You may need to consider a combination of strategies to minimize or eliminate taxation on your retirement income.
Setting yourself up with a variety of income sources that the IRS can’t tax you on during your golden years involves doing some work in advance. So, it’s important to talk to a financial professional. To help you get a head start, below is a guide to income that is taxable, partially taxable and tax-free.
Taxable Income in Retirement
Traditional Retirement Plans
Contributions to retirement plans, such as a traditional 401(k), 403(b), traditional IRAs and SEP IRAs, offer a number of tax advantages. Since you are funding them with pre-tax dollars, you receive an immediate tax break – tax-deferral on your income and gains until you withdraw your money, assuming you are at least 59½ (there is a 10% penalty on premature withdrawals). However, when you retire, any withdrawals will be taxed at your income tax rate.
Most pensions are funded by employers with pre-tax income. That means that if you are lucky enough to have a pension to depend on, the monthly income will be taxed at your regular income tax rate (unless the payment is a qualified distribution from a Roth account or contributions were made with after-tax dollars). If you take a lump sum payout, you must pay the total tax due in the year you file your tax return, which can also move you into a higher tax bracket.
Non-Retirement or Brokerage Accounts
If you buy stocks, bonds or mutual funds and hold them for more than a year, any gain is considered long-term. The taxation on long-term gains depends on your income and is taxed at either 0%, 15% or 20%. For example, if your taxable income falls below $41,675 for single filers and $83,350 for married filers in 2022, the rate is zero (0%), so you won’t pay taxes on your gains. Those with incomes above these thresholds will pay capital gains tax on the income as it is earned. Investments held for less than a year will be taxed as ordinary income.
Partially Taxable Income in Retirement
Social Security income may be taxable anywhere from zero (0%) to 85%. That means that a minimum of 15% will always be tax-free. If Social Security is your only source of income, you’ll generally avoid paying taxes on the benefits you receive. The calculation involves adding your non-Social Security income (known as your provisional income) to half of your annual Social Security benefit. If the amount is less than $32,000 for married tax filers or less than $25,000 for single filers in 2022, you will avoid federal taxes on your benefits.
If you happen to live in one of the 37 states (plus the District of Columbia) that are kind enough not to tax Social Security benefits, you won’t have to worry, as your benefits will be tax-tree. However, everyone else will likely pay federal and state income tax on what they receive from Social Security — but remember, at least 15% will be tax-free.
Annuities Funded with Non-Retirement Money
If you purchased an annuity with after-tax money (meaning, you already paid taxes on the money before it goes into the annuity, also known as a non-qualified annuity) only the interest or earnings are taxable. Said another way, the principal is tax-free, but the gains are not. Thus, when you take a distribution, the gain must be withdrawn first, and it will be taxed as ordinary income. Also, keep in mind that as with annuities funded with pre-tax money such as an IRA, withdrawals before the age of 59½ will be assessed a 10% penalty on the earnings (exceptions apply due to death or disability).
Cash Value in Life Insurance Policy upon Surrender
If you have a permanent life insurance policy that builds cash value, such as whole life or universal life, you can generally access the funds through a withdrawal, a loan, or by surrendering or canceling the policy. The premiums paid plus excess earnings or investment gains build cash reserves within the policy. If you surrender the policy, the insurer pays out the cash value minus surrender fees (depending on how long you’ve had the policy). The gain on the policy is subject to income tax (additional taxes may be incurred if you have an outstanding loan balance). For example, if you surrender a $20,000 policy and the total premiums paid, or the cost basis, is $10,000, the additional $10,000 will be taxed as income.
Tax-Free Income in Retirement
Roth IRAs and Roth 401(k) Withdrawals
Contributions to Roth IRAs are made with after-tax money, and withdrawals are tax free, as long as you meet the requirements (must have account for five years and be at least age 59½). Note: Because your contributions were made with money you’ve already paid taxes on, you can withdraw those contributions at any time tax-free and penalty free. However, you may be subject to taxes and a 10% penalty on investment earnings (monies in the account that exceed your original deposit) if you’ve had the Roth IRA for less than five years and you are under age 59½.
Withdrawals from Roth 401(k)s (as well as a Roth 403(b)s and Roth 457(b)s), are also tax free, but unlike Roth IRAs, you can fund them regardless of what you earn, provided your employer offers this plan option.
Health Savings Accounts (HSAs)
Health savings accounts (HSAs) are self-directed and self-funded plans designed to help individuals meet their current and future qualified medical expenses not covered by insurance on a tax-tree basis. They are available to those enrolled in a high-deductible health plans (HDHPs) offered by many insurance companies. HSAs are triple tax advantaged, meaning that contributions, interest or earnings, and distributions for qualified medical expenses (i.e., deductibles and copays) are not subject to federal income tax. Funds in an HSA do not have an expiration date, which means you can carry unused funds from one year to the next. Individuals can contribute a maximum of $3,650 in 2022 ($7,300 for families) and if you are age 55 and older, you can contribute an additional $1,000.
Those nearing or already in retirement, tend to favor investing in less risky investments, such as bonds. Generally speaking, when you invest in bonds, you have to pay federal and state taxes on the income you receive. However, interest earned from municipal or “muni” bonds, in particular, is exempt from federal income taxes. If the muni bond is issued in your state of residence, you may also be exempt from state and local taxes too. For example, if you reside in California and you buy muni bonds issued in California, you will avoid state income tax on them.
A reverse mortgage allows senior homeowners (62 years of age or older) with a considerable amount of equity to convert it into cash during their retirement years to provide additional income. Lenders make payments to the homeowner rather than the homeowner making payments to the lender. Payments received are considered loan proceeds or advances and thus, are not taxable.
Gain from the Sale of Your Primary Residence
Gains from the sale of your primary residence generally come with an exclusion: If the profit from the sale of your home is less than $500K for married filers and $250K for single filers and you meet the IRS’s ownership and use tests (i.e., you’ve owned and lived in your home for at least two out of the last five years), you will avoid paying capital gains.
Withdrawal of Cash Value in Life Insurance Policy
Cash value earned in a permanent life insurance policy can also serve as tax-free income during retirement. If you decide to take a withdrawal from your cash value, it will be tax-free up to the amount you paid into the policy.
When you retire, you’ll most likely continue to pay taxes, which can reduce your available income. Fortunately, there are steps that you can take now to minimize your taxation and retain more income later in life. Doing so requires gaining an understanding of the tax rules that apply to the different types of income you may receive. Plan ahead. Consult with a financial and/or tax professional because many decisions to reduce your tax bill during retirement need to be made early.