How you make retirement withdrawals will affect your tax brackets. This can be a fairly complicated issue. Depending on which plans you have, your retirement withdrawals might be considered taxable income, taxable capital gains or untaxed earnings. For each taxable segment of your withdrawals, the amount that you take will determine your taxable earnings and, therefore, your tax bracket. Planning for this is part of a smart retirement strategy. Here’s what you need to know.
If you need help planning your withdrawals, a financial advisor can help you develop a retirement strategy.
Categories of Taxes That Retirement Accounts Can Trigger
One of the most important things to consider when planning your retirement is your taxes. And Graham Ortmann, a CPA with financial education company Zogo, told SmartAsset in an interview that in addition to one-off events like selling your house or moving, you will need to know if and when you have to pay taxes on your retirement plans.
“Withdrawals from different types of retirement accounts can also impact your taxable income,” he said. “For instance, qualified Roth withdrawals are not taxable, while withdrawals from traditional 401(k) funds or IRAs would be.”
Overall, there are three categories of retirement withdrawal you can take:
Untaxed
Roth-style accounts are known as post-tax retirement accounts. You pay taxes on the money you deposit, receiving no benefit during your working years. Then, in retirement, you can withdraw this money tax-free, meaning that you pay nothing on the portfolio’s gains.
It’s usually a good idea to maximize your post-tax accounts first as part of retirement planning, as this saves most people far more money than a pre-tax account.
Taking money from an untaxed account will not change your tax status. This money does not contribute toward your taxable income for the year, and so will not affect the tax bracket of any other withdrawals or income.
Ordinary Income
Withdrawals from pre-tax retirement plans, such as 401(k) and IRA accounts, are taxed as ordinary income. This rule applies even if you take withdrawals based on the sale of stocks or other assets that would ordinary constitute capital gains. This money is applied to your taxable income for the year and will affect your income tax bracket.
Capital Gains
Most, if not all, tax-advantaged retirement accounts do not trigger capital gains taxes. Instead, withdrawals are treated as either ordinary income (if made from a pre-tax account) or untaxed income (if made from a post-tax account).
However, withdrawals from a standard portfolio with no specialized tax advantages may trigger capital gains based on the nature of your returns. Typically, actions such as selling stocks or bonds from a standard portfolio will apply to your capital gains tax bracket for the year.
Withdrawals Determine Your Taxable Income
“To best plan for your tax situation, think about your expected sources of income and deductions and whether you expect to be in a higher or lower bracket than you are now,” said Ortmann. “If you’ll be in a higher bracket, consider investments and accounts that offer tax-free or tax-advantaged withdrawals. If you’ll be in a lower tax bracket, you may want to consider investments and accounts that can lower your tax liability in the present.”
Your tax bracket in retirement works, in one sense, exactly the same as it does during your working life. The more money you withdraw from a pre-tax retirement account, the higher your income will be and the higher your income tax bracket. The more capital gains you generate from a non-advantaged investment portfolio, the higher your capital gains tax bracket.
Specific Tax Implications of Withdrawals
Here are four important considerations to take into account regarding the tax consequences of various types of income as well as capital gains:
Social Security
The first issue to consider is Social Security. Based on your tax status and household earnings for the year, the IRS may apply 0%, 50% or 85% of your Social Security benefits to your taxable income for the year. This will set a baseline for your annual taxable income, since starting at age 70 you must take Social Security benefits.
For example, say you are an individual with more than $34,000 in household income. You collected $21,000 in Social Security benefits last year. The IRS would apply 85% of those benefits to your taxable earnings. This comes to $17,850 in taxable benefits which, in 2023, would start you off in the 12% tax bracket.
Tax-advantaged retirement accounts
You can disregard any withdrawals that you make from a post-tax account, such as a Roth IRA or a Roth 401(k). Since these accounts generate untaxed earnings, withdrawals do not increase your taxable income for the year.
You would apply any withdrawals that you make from a pre-tax account, such as a 401(k) or an IRA. The IRS considers this money ordinary income. You add this to your taxable Social Security benefits for the year as part of your overall taxable earnings.
For example, say you withdraw $50,000 from your 401(k) for the year. You also have the $17,850 in taxable Social Security benefits. Your taxable earnings are now $67,850 which, in 2023, would put you in the 22% tax bracket.
Taxable income
Finally, add any other sources of taxable income for the year, such as money you earned from work or non-tax advantaged portfolio earnings that count as income. The final total is your overall earnings for the year, and will determine your tax bracket.
For example, say that you rent out a room on Airbnb that generates $5,000 per year in additional income. You would add this to your Social Security benefits and portfolio withdrawals for a total taxable earnings of $72,850. This would still keep you in the 22% tax bracket.
Capital Gains
Beyond earnings, it’s also important to account for any capital gains taxes that you owe during the year. These are generated from your private portfolio transactions, meaning any money you take from a non-tax advantaged investment account. Typically you generate capital gains by selling financial assets such as stocks, bonds and funds that you have held for more than 12 months. The amount you make from these sales determines your capital gains tax rate for the year, and is separate from your income tax rate.
Bottom Line
If you withdraw money from a pre-tax retirement account, such as a 401(k) or an IRA, those withdrawals will apply to your income tax bracket for the year. Taking money from a post-tax account, such as a Roth IRA or a Roth 401(k), will not increase your taxable income and so will not apply to your income tax bracket. By managing how much money you withdraw, and from which account, you can manage your taxes on an annual basis.
Retirement Tax Planning Tips
A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Planning for taxes really doesn’t stop in retirement. In fact, it’s very important to have an effective strategy for making your withdrawals tax-efficient.
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