As you near or enter retirement, it is important to identify the different income streams that will become available to you. How much you pay in taxes depends on what type of accounts you have and where your retirement funds come from.
Proactive tax planning can help save you money during retirement. Here are a few ways that your income will be taxed during retirement:
One thing to note: Illinois exempts nearly all retirement income from state taxation, including Social Security retirement benefits, pension income and income from retirement savings accounts. Federal taxes still apply.
Traditional Retirement Plans
During our working years, we contribute to retirement plans such as traditional 401(k) or 403(b). These accounts are funded with pre-tax dollars and allow for a tax deduction. Their savings, dividends, and investment gains within the account continue to grow on a tax deferred basis.
At age 59 ½ you can begin taking withdrawals. By age 72, you will be required to take RMD (required minimum distributions). The tax rate you would pay on these withdrawals would be your ordinary income tax rate. Any withdrawals pre 59 ½ are subject to a 10% penalty on top of regular taxes.
Most pensions are funded with pretax income, which means the full amount of your pension benefit would be taxable when you receive the funds. Any pension income you receive will be taxed at your ordinary income rate.
You can choose to take a lump sum payout. If you do, you will owe tax on the full amount you receive. This could move you into a higher tax bracket. Another option would be to rollover your pension into a traditional retirement account. Future withdrawals will then be taxed similarly to amounts withdrawn from retirement plans.
A brokerage account is an example of a taxable account. It often holds assets such as stocks, bonds, mutual funds, or ETFs (exchange-traded funds). These accounts don’t have any tax benefits, but they offer more flexibility.
Selling an investment after owning it for less than a year results in a short-term capital gain, which is taxed as ordinary income. Long-term capital gains result from selling an investment owned for more than one year and are taxed at 0%, 15%, or 20% depending on your income.
Taxation on your Social Security gets a little tricky. Anywhere from 0% to 85% of your Social Security income may be taxable. That means that at least 15% will always be tax-free.
If Social Security benefits represent your only source of income, you generally won’t pay taxes on the benefits you receive. You can calculate how much of your Social Security benefits are taxable by finding your provisional income:
Provisional income = Adjusted Gross Income + Nontaxable Interest + ½ of your Social Security Benefits
The IRS has a handy tool to help determine if your benefits are taxable. There’s an example of how Social Security benefits are taxed in the last section of this post.
Roth IRA or Roth 401(k)
Contributions to Roth accounts are made with after-tax money and are not tax deductible. You can contribute to both plans in the same year up to the allowable limits The benefit is future qualified withdrawals are tax free, including any gains.
There are no income limits on Roth 401(k)s. However, Roth IRAs follow these contribution limits:
Two main items to consider before withdrawing is that you must have the account open for five years and you must be 59 ½ to receive tax free withdrawals. Otherwise, you may have to pay taxes and a 10% penalty on investment earnings.
Keep in mind that since you contribute after-tax dollars to a Roth, you can withdraw those contributions at any time without worrying about taxes or penalties.
A Municipal bond is a debt security issued by a state, municipality, or county to finance its capital expenditures. Income from “muni” bonds is generally free from federal taxes. However, depending on your state, you may still owe state taxes on the related income.
If you sell your home, you may be able to exclude your gain from taxes. The IRS allows you to avoid paying taxes on up to $500,000 in profits from the sale if you are married, or up to $250,000 in profits if you are single. You must have owned and lived in your home for at least two out of the past five years for this exclusion to apply.
Real Life Scenario
For example, suppose that you’re a married couple, age 64, and filing a joint return with your spouse. You estimate you will receive the following benefits:
$50,000 from Social Security
$20,000 from Pension
$10,000 from 401(k)s
$10,000 from Roth IRA
Your total income, not including Social Security benefits, is $30,000 ($20,000 from pension + $10,000 from 401(k)). The $10,000 Roth distribution is tax free.
Your provisional income would be $30,000 + $25,000 (half SS benefit) = $55,000. Which is $11,000 above the upper $44,000 threshold. This means that $15,350 of benefits are subject to taxation (50% of the amount from $32,000 to $44,000 plus 85% of the excess above $44,000).
That means your taxable income would be $45,350 ($30,000 + $15,350).
Your standard deduction for 2022 would be $25,900. Using that deduction, your total estimated taxable income would be $19,450 ($45,350 – $25,900), placing you in the 12% tax bracket for your top dollars. You’ll pay 10% on the first $20,550 of taxable income and 12% on income that falls between $20,551 and $45,350.
Your estimated tax bill would be $5,031. Any additional long term capital gains would qualify for the 0% tax rate because you are below the $83,350 of taxable income.
Sources / Disclaimers:
Illinois Tax Rules on retirement income from Illinois.gov
Income Taxes on Your Social Security Benefits from IRS.gov
This post focuses on tax brackets for single and married filers. If you are married and file separately your brackets will be different.
Additional tax benefit: If you are 65 or older you get an extra $1,750 standard deduction for tax year 2022. If you are married and filling jointly and both are 65 or older, the standard deduction increases by $2,700. If only one spouse is 65 or older it’s $1,350.
Please consult your financial advisor regarding your specific situation. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice.