When you retire, you’ll likely draw your income from several sources—such as retirement accounts, taxable investment accounts, and Social Security Benefits. Each of these sources is taxed according to its own rules. So, in order to accurately plan for your retirement, you need to know what these rules are, whether (and when) you’re required to make withdrawals, and how paying taxes on distributions will impact your overall financial goals.
Here’s a breakdown of the most commons sources of retirement income and how they’re taxed:
Traditional IRA and traditional 401(k)
Withdrawals from traditional tax-deferred retirement accounts are taxed at your normal income tax rate. Once you reach a certain age, you must start taking—and paying taxes on—required minimum distributions (RMDs). The IRS changed RMD rules in 2020.[1] If you reached age 70½ in 2019, you should have taken your first RMD by April 1, 2020. If you reached age 70½ in 2020 or later, you are required to take your first RMD by April 1 of the year following the year you turn 72.
Roth IRAs
Because contributions to Roth IRAs are made with after-tax money, withdrawals from these accounts are tax-free. You can withdraw contributions to your Roth account at any age; however, withdrawals on earnings before age 59 ½ are subject to early withdrawal penalties. Roth IRAs do not have RMDs like traditional IRAs, so your money can continue growing in the account. Because withdrawals from Roth IRAs are tax-free, consider making withdrawals from this account last to allow your savings to benefit from tax-free growth for as long as possible.
Taxable investments
Profits from the sale of stocks, bonds, and other investments outside of tax-advantaged retirement accounts are taxed at capital gains rates, which vary depending on how long you’ve owned the investments. Short-term capital gains are taxed as ordinary income and apply to investments you’ve owned for one year or less. Long-term investments, those held for more than a year before selling, are subject to preferential long-term capital gains rates of 0%, 15%, or 20%, depending on your tax bracket.[2]
Social Security
The tax rate for Social Security benefits depends on your provisional income, which is the sum of your adjusted gross income, tax-free interest from other investments, and 50 percent of your Social Security benefits. You’ll have to pay taxes if your provisional income exceeds $25,000 on an individual tax return or $32,000 on a joint return. Only up to 85% of your Social Security Benefits are subject to tax.[3]
Annuities
You typically purchase an annuity with after-tax income. The annuity then pays out income over time. The portion of the payment representing your principal is tax-free, and you’ll pay taxes on any earnings. If you purchased the annuity with pretax funds, such as from a traditional IRA, your entire payment would be taxed as ordinary income.
Making a withdrawal plan
Once you understand how your retirement income is taxed, you can make a tax-efficient plan to support you in your retirement years. You might consider a plan that looks like the following:
- Taking withdrawals from traditional IRA and traditional 401(k) accounts first to satisfy annual RMDs.
- Next, take withdrawals from taxable accounts.
- Take withdrawals from Roth IRAs, and Roth 401(k) accounts last. The longer you can avoid drawing down these plans, which aren’t subject to RMDs, the longer they can benefit from tax-free growth.
A careful withdrawal plan—and keeping your money in tax-exempt accounts as long as possible—can help you maximize your investment returns while minimizing the taxes you’ll owe.
Important Disclosure Information
The comments above refer generally to financial markets and not Bazis Young portfolios or any related performance. The content of this article should not be considered financial advice. The article is not intended to offer specific investment recommendations and is general in nature and should not be considered a comprehensive review or analysis of the topics discussed. This article is not a substitute for a consultation with an investment adviser in a one-on-one context whereby all the facts of the attendee’s situation can be considered in its entirety and the investment adviser can provide individualized investment advice or a customized financial plan. Opinions expressed are current as of the date shown and are subject to change. Past performance is not indicative of future results and diversification does not ensure a profit or protect against loss. All investments carry some level of risk including loss of principal. Information or data shown or used in this material was received from sources believed to be reliable, but accuracy is not guaranteed. This information does not provide recipients with information or advice that is sufficient on which to base an investment decision. This information does not consider the specific investment objectives, financial situation or need of any particular investor and may not be suitable for all types of investors. Recipients should consider the content of this information as a single factor in making an investment decision. Additional fundamental and other analyses would be required to make an investment decision about any individual security identified in this report.
Bāzis Young Investment Group, LLC is a registered investment adviser with the Securities and Exchange Commission. Registration as an investment adviser does not imply any level of skill or expertise. Any discussion of specific securities is provided for information purpose only and should not be deemed as investment advice or a recommendation to buy or sell any individual security mentions or to allocate assets in any manner discussed.
[1] Source: Internal Revenue Service: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds
[2] Source: Internal Revenue Service: https://www.irs.gov/taxtopics/tc409
[3] Source: Social Security Administration: https://www.ssa.gov/benefits/retirement/planner/taxes.html