Retirement and Taxes: Some Things Never End!

 

 

Income from various retirement sources may be subject to different tax rates and rules.  The following summarizes some of the sources of retirement income and how it will be taxed.

 

Payments you receive from an employer’s defined benefit pension plan are generally taxed at ordinary income tax rates.  A lump sum distribution that you roll over into an IRA, however, is not taxed until that money is withdrawn from the IRA – and then it is taxed as ordinary income.

 

When you withdraw tax-deferred contributions and earnings from Traditional IRAs and 401(k)s, the money is generally taxed as ordinary income.  If you have Traditional IRAs or 401(k)s that include non-deductible, after-tax contributions, withdrawals of those assets will not be taxed – although any earnings withdrawn will usually be taxed at ordinary income tax rates.

 

Keep in mind that you may also be subject to an additional 10% early distribution tax, if you take withdrawals before you reach age 59 ½.

 

Contributions to a Roth IRA or a Roth 401(k) have been made with after-tax income.  Therefore, both the original contributions and subsequent earnings can be withdrawn tax free, if certain conditions are met.

 

Qualified and non-qualified deferred compensation plans and agreements are normally ordinary income.  Quite often payors of these deferred amounts will withhold federal and state taxes from these distributions.

 

To determine whether any of your Social Security benefits may be taxable, compare the IRS “base amount” ($25,000 for individuals; $32,000 for married filing jointly), with your “total income” (defined as one-half of your Social Security benefits plus all your other income, including tax-exempt interest).  If your total income is more than your base amount, part of your benefits may be taxable up to 85% of the gross amount received during the year.

 

When you sell an appreciated asset held in a taxable account, any gain is taxed at your capital gains rate, which is 15%, if you have held the asset for more than one year and do not qualify for a lower rate.  If you have held the asset for one year or less, any gain is taxed at your ordinary tax rate.

 

Mutual funds make regular distributions of the interest and dividends they have received from the securities they hold – and they also distribute any gains from sales of securities the fund has realized.  Under current regulations, long-term capital gains and qualified dividends may be taxed at the “capital gains rate”, while short-term capital gains, non-qualified dividends, and interest are taxed at the same rate as your ordinary income.

 

Keep in mind that when you retire and begin receiving regular retirement account and pension distributions, you may have to make quarterly estimated tax payments for both Federal and State.  Or, you may elect to have these taxes withheld from your distributions.

 

After you retire, the order in which you withdraw assets from your accounts could directly affect how much after-tax disposable income you have.  Generally, you should withdraw from your taxable accounts first, tax-deferred accounts next, and tax-free accounts last.  This approach is designed to realize the benefits from tax-deferred growth potential for as long as possible.  Quite often a blend of these types of withdrawals can lead to the most advantageous tax results.

 

Depending on the number and types of accounts you will be relying on for income in retirement, some type of tax review and planning is recommended.

 

 James H. Barr, a certified public accountant, is a partner with Mengel, Metzger, Barr & Co. LP.  He may be reached at Jbarr@mmb-co.com.