- Retirement income can be tax-free, partially taxed, or taxed.
- Some investments are taxed as capital gains, some are taxed as ordinary income.
- States vary in what they tax and what they don’t: be familiar with your state’s laws.
Just because you’re retired doesn’t mean you get to stop paying taxes. But not all retirement income is taxed the same. When reviewing your retirement picture, it’s important to recognize that different accounts and income sources are taxed differently. Those taxes can potentially take a chunk out of your nest egg. Here, we examine eleven types of retirement income and how they are taxed.
Traditional IRAs, 401(k)s, and 403(b)s
When you put money into your traditional IRA, taxes on those funds are deferred. When you make withdrawals from your IRA, 401(k) or 403(b) this money is taxed as ordinary income. Required minimum distributions start at age 72.
Since the money you put into your Roth IRA wasn’t tax deductible (you already paid taxes before you deposited the money), Roth IRAs are not subject to taxes on withdrawals. There are only two caveats:
- You must have owned the account for at least five years.
- You must be at least 59 and a half before you start making withdrawals on the gains, or you’ll be subject to a 10% penalty.
You can withdraw the contributions you made at any time, since you’ve already paid taxes on them.
Some people don’t pay taxes on their Social Security income, but only if their “provisional income” is below a certain level.
To calculate your provisional income, take your modified-adjusted gross income, add half of your Social Security income and all of your tax-exempt bond interest.
If your provisional income is below $25,000 for a single person or $32,000 if you are married, filing jointly, Social Security income is tax-free.
If your provisional income is between $25,000 and $34,000 for a single person, or between $32,000 and $44,000 for a married couple, your Social Security income is taxed up to 50%.
If your provisional income is more than $34,000 or $44,000 for married couples, then up to 85% of your Social Security benefits may be taxable.
As of right now, thirteen states also tax social security income: Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, and West Virginia. They all have different provisions and laws, so you’ll need to learn your state's rules.
Is your pension taxable? If your employer contributed the money to your pension fund, then that money is taxable as income. If you added to your pension fund with your own after-tax dollars, you don’t have to pay taxes on that portion.
You’ll pay ordinary federal income taxes on pensions. Your pension provider should send you a 1099 form that explains what portion of your pension is taxable.
Some states tax pension income and others don’t. You’ll have to check on your state’s rules around pension income.
Stocks, bonds and mutual funds
Money you get from selling stocks, bonds, or mutual funds you’ve held for more than a year are taxed as long-term capital gains. The IRS sets the rates annually according to income:
- If you’re single with an income of less than $40,000 or a married couple with an income of less than $78,750, your capital gains tax rate is 0%
- If you’re single with a taxable income of more than $40,000 but less than $434,550 or between $78,751 and $488,850 if you’re married filing jointly, your capital gains tax rate is 15%.
- If you’re single with a taxable income of more than $434,550 or married filing jointly with an income over $488,851, your capital gains tax rate is 20%.
If you sell an investment before you’ve had it for a year, that’s a short-term capital gain and it’s taxed as ordinary income. Vice versa, you can also have capital losses if you sell investments at a loss. Losses can be used to offset taxable income up to $3,000 and can be carried over.
CDs, savings accounts and money market accounts
The interest you earn on CDs, bonds and money market accounts are taxed at your ordinary income tax rate.
Savings bonds are taxable at your ordinary tax rate, either the year they mature or the year they’re redeemed, whichever is earlier.
Interest on HH bonds should be reported on and taxed annually. Interest on savings bonds are not taxed at the state or local level.
When you buy an annuity to provide income for retirement, the principal is not taxed but any money earned on the investment is taxed as ordinary income. So, if you bought a $100,000 annuity and ten years later it’s worth $120,000, the $20,000 is taxable upon distribution.
If you used pre-tax dollars to buy the annuity, such as an IRA or other retirement account, then the total amount is taxable.
Dividends paid to you from stocks, bonds, or mutual funds are either qualified or ordinary. Qualified means they are taxed at long-term capital gains rates. Ordinary dividends are taxed as ordinary income.
In order for an investment to be qualified, you must have held the stock for at least 61 consecutive days in any 121 day period, 60 days before and 60 days after the dividend.
Municipal bond interest is tax-exempt at the federal level, and probably at the state level as well, but you should check your state’s laws to make sure.
If you sell your municipal bonds, you’ll be subject to capital gains taxes if the price increased.
If you receive a death benefit from someone else’s policy, you will not be taxed on that money.
If it’s your own policy and you earn cash value, it should be tax-free as well, as long as it doesn’t turn into a modified endowment contract (MEC). Your insurance company should let you know if your policy is in danger of becoming an MEC.
If all of this seems a tad confusing, you’re not alone. Tax laws change all the time. To help you get the most out of your retirement and pay the least (legal) amount of taxes, talk to a Certified Financial Planner who can help take a look at your assets and your potential tax liabilities.