Taxes in retirement: What you need to know
When you start drawing down assets in retirement, the federal tax implications can be confusing. Here are some tips to consider when working toward creating a tax-efficient strategy that can help you enjoy these years to the fullest.
Questions about taxes don't end in retirement. Your tax bracket may shift, up or down. And the order in which you tap your retirement accounts and other savings could have a big impact on how much tax you owe — and consequently, how long your retirement assets could last.
Do you know whether your withdrawals will be tax-free? If they won't be, will they be taxed at your federal ordinary income tax rate or at the federal long-term capital gains rate? "Just as it's sensible to pay attention to tax-efficient ways to save for retirement when you're younger, you should start thinking about the tax effects of drawing from your retirement accounts as you approach retirement," says David Koh, managing director and senior investment strategist, Chief Investment Office, Merrill and Bank of America Private Bank.
You should start thinking about the tax effects of tapping your retirement accounts as you approach retirement.
— David Koh,
managing director and senior investment strategist, Chief Investment Office,
Merrill and Bank of America Private Bank
Consider the tips below as you work with your tax professional in developing an approach to help minimize your effective federal tax rate and the amount of your federal tax liability. State and local taxes are not addressed in this article, and you should consult your tax advisor about state and local taxes.
Know how different types of income are taxed
As you approach or reach retirement, identify all the sources of income you may have in retirement, which might include annuities, pensions, qualified retirement plans such as 401(k)s and IRAs, and Social Security. "Understanding how various accounts are taxed in retirement is crucial as you're figuring out a sensible order for withdrawing from them," says John P. Schultz, partner at Genske, Mulder & Company and chair of the California Society of Certified Public Accountants tax committee.* But making those plans without the help of a professional can be challenging.
This table displays the various retirement tax rates based on income source. Roth IRA or Roth 401(k) qualified distribution income is tax-free. Traditional IRA, traditional 401(k), pension or annuity distributions, short-term capital gains, bond income and non-qualified dividends income is taxed at your ordinary income rate. Social Security income is taxed at your ordinary income rate for up to 85% of your benefits; the rest is tax-free. Long-term investment gains, including qualified dividends, is taxed at the long-term capital gains rate (plus a potential 3.8% net investment income tax).
Sources:
IRS.gov Publication 590-B (2022), Distributions from Individual Retirement Arrangements (IRAs); Publication 575 (2022), Pension and Annuity Income; IRS Topic No. 404 Dividends, Aug. 2022.
SSA.gov "Income Taxes and Your Social Security Benefit," accessed Jan. 2023; IRS Topic No. 559 Net Investment Income Tax, accessed Jan. 2023.
Contributions to a designated
Roth 401(k) account or Roth IRA are federally tax-free when you withdraw those funds, as are the earnings, assuming the withdrawal is a qualified distribution, which generally means it is made after a five-year waiting period and the account owner is
59½ or
older.Footnote 1 Upon distribution, principal contributions to non-qualified annuities are generally tax-free, though any earnings on those accounts are generally included in your taxable income upon distribution.
On the other hand, withdrawals from traditional 401(k) plan accounts and certain other employer-sponsored plans, as well as traditional IRAs — basically, any retirement plans funded with pretax or tax-deductible money — will generally be subject to federal and state ordinary income taxes upon withdrawal.
In your nonretirement accounts, bond income and some of the dividends you receive from stocks and mutual funds may be taxed at your federal ordinary income rate, but qualified dividends and long-term investment gains are generally taxed at lower long-term capital gains rates. State and local tax treatment may vary. Finally, don't forget Social Security. Depending on how much income you collect from other sources, up to 85% of your benefits may be considered taxable income. Your tax professional can help you put in place a plan for your future retirement income.
Develop a thoughtful withdrawal strategy
"For some people, it will make sense to consider tapping taxable accounts first, then tax-deferred and finally tax-free," says Debra Greenberg, director, Investment Solutions & Personal Retirement, Bank of America. "But, depending on your circumstances, this order may not be right for every person." If most of your investment gains are from long-term assets held outside of IRAs and similar tax-deferred accounts, you'll likely pay long-term capital gains taxes, which are generally lower than what you pay on distributions taxed as ordinary income from your 401(k)s, traditional IRAs and certain other tax-deferred investments. "Also, remember that if you're not accessing your retirement funds, they're still growing tax-deferred," Greenberg says.
For some people, it will make sense to consider tapping taxable accounts first, then tax-deferred and finally tax-free.
— Debra Greenberg,
Director, Investment Solutions & Personal Retirement,
Bank of America
That said, if you're an active investor, you may end up owing more in taxes than you expect when you sell investments held for one year or less in taxable accounts, since those gains don't qualify for the lower, long-term capital gains rate, says Koh. "You'll need to decide whether to hold the asset longer as it appreciates, and your tax rate becomes more favorable, or sell it and take your gains now. It's a delicate balance," he notes. Keep in mind, too, that under current law, you could boost your tax-free assets by converting traditional IRAs to Roth IRAs, which offer tax-free qualified distributions when certain conditions are met and generally don't have required minimum distribution (RMD) requirements during the account owner's lifetime.
Even if you're not yet retired, you'll need to consider the impact of your retirement savings on your taxes once you reach age 73 (or age 75 after 2032). That's when you must begin taking RMDs from some of your retirement accounts, which is likely to boost your taxable income.Footnote 2
Watch out for moves that could put you in a higher tax bracket
RMDs and other changes that bump up your income can result in what's called "bracket creep" — which is, basically, unexpectedly slipping into a higher tax bracket. You might, for instance, receive an inheritance or sell a piece of real estate. You might also slip into a higher tax bracket by taking a large distribution from a taxable account to, say, renovate your home or buy a new car, Schultz notes. "When you're in retirement, even a small change in your income can have an impact on what you pay in taxes, cutting into the amount you were expecting as cash flow," says Schultz. He also points out that a higher income can affect the taxability of your Social Security benefits and push up your Medicare premiums.
When you're in retirement, even a small change in your income can have an impact on what you pay in taxes.
— John P. Schultz,
CPA and partner,
Genske, Mulder & Company
This is one reason it can be useful to fund different kinds of retirement accounts during your working years. Weighing your choices now can give you a greater degree of control in retirement — you can manage the amount of taxable income you receive and make adjustments when necessary. For instance, when you start taking RMDs, it might make sense to take any additional withdrawals from tax-free accounts instead of taxable ones, suggests Greenberg. You can also pay for qualified medical expenses with your health savings account, and since those qualified withdrawals are tax-free, they won't affect your taxable income. Talk to your tax professional anytime you expect a temporary income bump.
Review your tax situation whenever your life changes
A number of life events, says Greenberg, could trigger a change in your tax circumstances: taking Social Security, deciding to stay at work or return to it part time, relocating to a more (or less) tax-friendly state, dealing with increased healthcare costs or other expenses. Whenever you see a change like this on the horizon, it's time to check in with your tax professional.
Another reason for periodic conversations, says Koh, is that tax laws can change. For example, increases in capital gains rates and higher rates for wealthier taxpayers were both discussed on Capitol Hill in the past year. For all these reasons, your best bet is to regularly check in with your tax pro, says Greenberg. "There's no one-size-fits-all rule for managing taxes in retirement. The most important thing to remember is that you don't have to make these decisions alone."
Footnote 1 Generally, for a distribution from a Roth IRA to be federal (and possibly state) income tax-free, it must be qualified. A qualified distribution from your Roth IRA may be made after a five-year period has been satisfied (this period begins Jan. 1 of the tax year of the first contribution or the year of conversion to any Roth IRA) and you are age 59½ or older, (ii) are disabled, (iii) or qualify for a special purpose distribution such as the purchase of a first home (lifetime limit of $10,000). In situations where the original account owner is deceased, distributions to the beneficiary are also considered a qualified distribution If you receive a non-qualified distribution from your Roth IRA, the earnings portion of such distribution generally will be subject to ordinary income tax, plus a 10% early withdrawal additional tax if received before age 59½ unless an exception applies. A 10% early withdrawal additional tax may also be owed on converted Roth IRA principal withdrawn before the end of the five-year period. Although RMDs are not required for the original account owner, RMDs would apply to the inherited IRA account.
Footnote 2 Effective Jan. 1, 2023, the required beginning date for RMDs is Apr. 1 of the year after you turn age 73. You are required to take an RMD by Dec. 31 each year after that. If you delay your first RMD until Apr. 1 in the year after you turn 73, you will be required to take two RMDs in that year. You may be subject to additional taxes if RMDs are missed. Please see your tax advisor regarding your specific situation.
IMPORTANT DISCLOSURES
* As a CPA and partner at Genske, Mulder & Company, John P. Schultz is not affiliated with Merrill or any of its affiliates. Opinions and views expressed are his, do not necessarily reflect those of Merrill or any of its affiliates and are subject to change. Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
Investing involves risk including the possible loss of principal. Past performance is no guarantee of future results.
All recommendations must be considered in the context of an individual investor's goals, time horizon, liquidity needs and risk tolerance. Not all recommendations will be in the best interest of all investors.
Opinions are as of Jan. 19, 2023, and are subject to change.
This information should not be construed as investment advice and is subject to change. It is provided for informational purposes only and is not intended to be either a specific offer by Bank of America, Merrill or any affiliate to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service that may be available.
The Chief Investment Office (CIO) provides thought leadership on wealth management, investment strategy and global markets; portfolio management solutions; due diligence; and solutions oversight and data analytics. CIO viewpoints are developed for Bank of America Private Bank, a division of Bank of America, N.A., ("Bank of America") and Merrill Lynch, Pierce, Fenner & Smith Incorporated ("MLPF&S" or "Merrill"), a registered broker-dealer, registered investment adviser and a wholly owned subsidiary of Bank of America Corporation ("BofA Corp.").
MAP5711569-05262024