Retirement and Income Taxes

Making the leap from paid employment to retirement is a huge step. There are many things to consider including where the funds will come from to satisfy your living expenses. Many people often overlook, or may not even be aware of, how income taxes impact their retirement.

Like most things related to the tax code, there are numerous rules to consider when deciding how to fund retirement. The choices you make may ultimately leave you with additional funds to enjoy your retirement or assist loved ones or favorite charities. A little retirement income tax planning can go a long way towards reducing some of the financial and psychological stress of funding retirement.

Retirement Asset Tax Treatment

Determining how to fund your retirement can be a bit overwhelming. There are numerous types of retirement assets such as brokerage accounts, IRA’s, annuities, and fixed income options like pensions and Social Security. Each retirement asset has its own tax treatment that must be considered. I briefly describe the general tax treatment of many popular options below.

Retirement Asset	Tax Treatment
Cash – Savings, Checking, Money Market, CD	No tax on withdrawals. Interest taxed as ordinary income.
Taxable Brokerage Account	No tax on principal or cost basis. Favorable long term gain rates applied to profits for securities held greater than one year. Short term gains (ordinary income) applied to profits for securities held less than one year. Bond fund and cash dividends taxed as ordinary income.
Private and Public Pensions	Typically taxed as ordinary income at the Federal level. State laws differ.
Social Security	Fifty to eighty percent of the Social Security benefit is subject to ordinary income tax depending on your income situation.
Annuities Held Outside of IRA Accounts (i.e. Non-Qualified Annuities)	Taxed as ordinary income except for principal (i.e. amount contributed to annuity).
Traditional IRA and 401(k) Withdrawals	Typically the entire withdrawal is taxed as ordinary income except for the amount of any after tax contributions.
Roth IRA Withdrawals	Qualified distributions are tax free.
Health Savings Accounts (HSA)	Withdrawals are tax free for qualified medical expenses. After age 65, you can pay for Medicare Part B, Part D, and Medicare HMO premiums tax-free. After age 65, you can withdraw funds for any purpose. The withdrawal is subject to ordinary income tax, but no penalty.

Retirement Funding Strategies

How should you fund your retirement each year with these different assets and associated tax implications? The conventional advice suggests using your taxable accounts like brokerage and cash first while letting your Traditional IRA, 401(k), and Roth IRA accounts grow as long as possible. Traditional IRA’s are tapped next as the taxable accounts become smaller. Roth IRAs are left for last since the earnings are never taxed and these accounts are often bequeathed to children and grandchildren.

For many individuals with large 401(k) and Traditional IRA balances this may not be best approach. The reason is that Traditional IRA and 401(k) accounts may grow to the point that Required Minimum Distributions (RMD) at age seventy and one half become quite large. The RMD is taxed as ordinary income which could lead to larger than anticipated tax bills after age seventy.

A better approach is to look at your tax situation during your retirement years before taking your first RMD. For years where you anticipate being in a lower income tax bracket, you might fund some of your retirement from Traditional IRA accounts. Alternatively, you could convert part of your Traditional IRA to a Roth IRA while paying ordinary income taxes on the conversion. In each case, you should keep an eye on your marginal tax bracket to make sure you aren’t moving too far up the income tax scale. You can also decide to use an HSA for medical related expenses or health insurance premiums to help manage your overall tax obligation each year.

Individuals with large retirement account balances should also consider when to take their Social Security. By delaying until age seventy and tapping Traditional IRA’s to make up the shortfall, you could end up reducing your future RMD’s. Furthermore, not all of the Social Security benefit is subject to income tax so this strategy could help you manage your tax situation at age 70 when RMD’s start.

Retirement Tax Payment Planning

No matter how you fund retirement, make sure to plan for your taxes each year. You can usually request that your Traditional IRA custodian withhold funds to pay Federal and State income taxes. You can sometimes request that your pension provider do the same. The Social Security Administration is able to withhold Federal income taxes. If you receive a significant amount of dividend, interest or capital gain income, you should submit quarterly estimated tax payments. Otherwise, you might end up being subject to a large tax bill and underpayment penalty when you file your income taxes.

Summary

The general advice provided in this article focuses on reducing your tax burden during retirement. The assumption is that by paying less in taxes, you end up with more funds available for your retirement and charitable giving goals. However, this is not always the case and you should make sure to review your specific strategy with the appropriate financial and tax professionals. Please also note that tax rules always change and that this information was provided within the context of current tax rules.