How Is Your Retirement Income Taxed?

May 15, 2013

Last month I took a phone call from a gentleman who is in the process of preparing for retirement. He has done a good job saving and now that he is getting ready to take distributions from his retirement accounts, he is concerned about taxes. We are often lead to believe that taxes will be less in retirement and for many taxpayers, that will be true not because of a change in the way things are taxed but rather because many retirees will be able to enjoy retirement on less income.  Income sources are taxed no differently in retirement than they are while we are working.  Sure, we receive an additional deduction once we turn 65, but the primary difference between our working and retired years is not how our sources of income are taxed, but the “sources” of income themselves.

Since we can’t escape taxes in retirement, there are some things we can do to minimize them.  In order to understand these tax-reduction strategies, it will help to start by knowing how different retirement income sources are taxed in retirement.  Here is a brief overview:

1. Sources taxed as ordinary income

Many retirement income sources will be subject to the same tiered income tax brackets that apply to ordinary income today.  These sources include:

Traditional retirement accounts, including IRAs, 401(k)s, and inherited retirement accounts are taxed in the year of distribution.

Pension benefits are taxed in the year received.

Social Security is taxable, but only a portion depending on the amount of total income from other sources.  To estimate the taxable portion of Social Security benefits, check out this handy calculator.

Ordinary dividends and interest from bank accounts, corporate bonds, and other types of investments is taxed as ordinary income.

Part-time work is taxed the same as full time work.

Rental income is taxed but this can be offset by deductions.

REITS pay dividends that are usually subject to ordinary income tax unless the dividend is qualified.

Tax-deferred annuities may be partially or fully subject to ordinary income tax depending on whether they are qualified (fully taxable) or non-qualified (only the earnings are subject to tax).

Non-qualified distributions from Roth accounts, 529 savings plans, and health savings accounts (HSA) are also subject to ordinary income tax as well as a penalty tax in some instances.

2. Sources taxed as capital gains

Some sources may be taxed at preferential capital gains tax rates.  These sources include:

Stocks and mutual funds are subject to long-term capital gains tax treatment if held for at least one year prior to sale.  Losses may be used to offset gains in the same year. Up to $3,000 in net losses may be deducted from income and losses that exceed $3,000 may be carried forward.

Real estate is a capital asset and therefore subject to capital gains tax treatment when sold. There is, however, a special exclusion that applies to the sale of a primary residence. If a taxpayer lives in a primary residence 2 of the previous 5 years before sale, the taxpayer may exclude up to $250,000 ($500,000 if married filing jointly) in capital gains from tax.

Qualified dividends are a special type of dividend that receives capital gains tax treatment.

Collectibles, such as coins, precious metals, antiques, and art, are a special type of capital asset that is taxed at a flat 28% rate unless held for less than one year.

3. Tax-free sources

Not all retirement income sources are taxable.  The following sources provide income free of income taxes:

Roth accounts, including Roth IRAs and Roth 401(k)s, are tax-free when the account has been open for at least five years and the owner is at least age 59½.  This is referred to as a qualified distribution.  Inherited Roth accounts are also tax free as long as the deceased owned the account for at least five years.

Health Savings Accounts (HSA) are also tax-free if funds are used for qualified expenses.  Funds used for non-qualified expenses are taxed as ordinary income and subject to a 20% tax penalty if withdrawn before age 65.

Municipal bonds pay interest that is generally tax-free at the federal level and may be tax-free at the state level if the taxpayer lives in the issuing community.

Inherited capital assets, while technically not tax-free, receive a step-up in cost basis at the time of death so selling an inherited capital asset shortly after receipt may generate little to no tax liability.

After-tax principal in a savings account may be spent without incurring additional tax liability.

While the list of income sources above is not exhaustive, it covers some of the more common sources of retirement income.  Knowing how these various sources are taxed, next week we can begin to look at some strategies for reducing taxes in retirement.