How Paying Tax on Savings When Retired Works

Understanding the tax implications of various income sources in retirement is an important aspect of financial planning. Income received during retirement can originate from diverse sources, each carrying its own specific tax rules. A basic understanding of how these different income streams are taxed helps individuals manage their finances effectively throughout their retirement years.

Taxation of Traditional Retirement Accounts

Traditional retirement accounts, such as Traditional IRAs, 401(k)s, and 403(b)s, generally involve contributions made with pre-tax dollars. This means that the money contributed to these accounts is not taxed in the year it is earned, allowing for tax-deferred growth over time. The investments within these accounts grow, and any earnings, dividends, or capital gains are not taxed annually.

When withdrawals begin in retirement, these funds are typically taxed as ordinary income. The entire amount withdrawn, including both the original contributions and any accumulated earnings, becomes subject to federal income tax at the individual’s current marginal tax rate. This is because the contributions and growth were never taxed before the point of withdrawal.

For individuals who made non-deductible contributions to a Traditional IRA, a portion of their withdrawals may be tax-free. These non-deductible contributions establish a “basis” in the IRA, representing amounts that have already been taxed. When distributions are taken, a pro-rata calculation determines the taxable and non-taxable portions based on the ratio of after-tax contributions to the total account balance.

Withdrawals from traditional retirement accounts before age 59½ are generally subject to a 10% early withdrawal penalty, in addition to being taxed as ordinary income. There are specific exceptions to this penalty, such as withdrawals for certain unreimbursed medical expenses, qualified higher education expenses, or a first-time home purchase, up to a lifetime limit of $10,000.

The “Rule of 55” offers another exception for 401(k) plans, allowing penalty-free withdrawals if an individual leaves their job in the year they turn 55 or later. While the 10% penalty is waived under this rule, the distributions are still taxed as ordinary income. This rule applies only to the 401(k) plan from the most recent employer.

Taxation of Roth Retirement Accounts

Roth retirement accounts, including Roth IRAs and Roth 401(k)s, operate under a different tax structure compared to traditional accounts. Contributions to Roth accounts are made with after-tax dollars, meaning the money has already been subject to income tax before it is invested. This fundamental difference allows for a significant tax benefit during retirement.

The key advantage of Roth accounts is that qualified withdrawals in retirement are entirely tax-free. This includes both the original contributions and all accumulated earnings. For a withdrawal to be considered qualified, two main conditions must typically be met: the account owner must be at least age 59½, and a five-year waiting period must have passed since the first contribution was made to any Roth IRA or Roth 401(k).

The five-year period begins on January 1 of the tax year for which the first contribution was made. This rule applies to both direct contributions and conversions from traditional accounts.

If withdrawals are made before meeting both the age and five-year requirements, they are generally considered non-qualified. In such cases, contributions can usually be withdrawn tax-free, as they were already taxed. However, the earnings portion of a non-qualified withdrawal becomes subject to ordinary income tax and may incur a 10% early withdrawal penalty, unless a specific exception applies.

Taxation of Non-Retirement Investments

Investments held in taxable brokerage accounts or other non-retirement vehicles are subject to different tax rules than retirement accounts. Income generated from these investments is typically taxed in the year it is received or realized. This includes capital gains, dividends, and interest income.

When an investment asset, such as a stock or mutual fund, is sold for a profit, the gain is classified as either short-term or long-term capital gain. Short-term capital gains arise from assets held for one year or less and are taxed at an individual’s ordinary income tax rates. Conversely, long-term capital gains result from assets held for more than one year and generally receive preferential tax treatment.

Dividend income also has varying tax treatments. “Qualified dividends” are paid by U.S. corporations or certain foreign companies and meet specific holding period requirements. These are taxed at the more favorable long-term capital gains rates. “Ordinary dividends,” which do not meet these criteria, are taxed at regular ordinary income tax rates.

Interest income, derived from sources like savings accounts, certificates of deposit (CDs), or most bonds, is generally taxed as ordinary income. However, interest from municipal bonds issued by state or local governments is typically exempt from federal income tax, and may also be exempt from state and local taxes if the bondholder resides in the issuing state. Some individuals with higher incomes may also be subject to a 3.8% Net Investment Income Tax (NIIT) on certain investment income.

Taxation of Social Security Income

Social Security benefits, a significant income source for many retirees, may be subject to federal income tax depending on the retiree’s overall income level. The Internal Revenue Service (IRS) uses a calculation involving “provisional income” to determine the taxable portion of these benefits. Provisional income is calculated by adding an individual’s Adjusted Gross Income (AGI), any tax-exempt interest income (such as from municipal bonds), and one-half of their Social Security benefits.

The amount of Social Security benefits subject to taxation depends on specific income thresholds. For single filers, if provisional income is between $25,000 and $34,000, up to 50% of Social Security benefits may be taxable; if it exceeds $34,000, up to 85% may be taxable. For married couples filing jointly, the thresholds are $32,000 and $44,000, respectively, with up to 50% taxable between these amounts and up to 85% taxable above $44,000.

The taxable portion of Social Security benefits is included in the individual’s taxable income and is taxed at their ordinary income tax rate. Understanding this calculation is important for retirees to anticipate their tax liability. While federal rules apply nationwide, some states may also impose taxes on Social Security benefits, though rules and exemptions vary.

Understanding Required Minimum Distributions

Required Minimum Distributions (RMDs) are mandatory annual withdrawals that individuals must begin taking from most traditional tax-deferred retirement accounts. The purpose of RMDs is to ensure that taxes are eventually paid on the contributions and earnings that have grown tax-deferred for many years. These distributions are typically required from Traditional IRAs, SEP IRAs, SIMPLE IRAs, and employer-sponsored plans like 401(k)s and 403(b)s.

For most individuals, RMDs generally begin in the year they reach age 73. The first RMD can be delayed until April 1 of the year following the year the individual reaches the RMD age. However, delaying the first RMD means taking two RMDs in that subsequent year, which could potentially push an individual into a higher tax bracket. Subsequent RMDs must be taken by December 31 of each year.

RMDs are calculated based on the account balance as of December 31 of the previous year and the account owner’s life expectancy, using tables provided by the IRS. The entire amount of an RMD is generally taxed as ordinary income, unless it represents after-tax contributions that were previously made.

A significant aspect of RMDs is the penalty for failing to take the required amount by the deadline. The IRS imposes a steep excise tax on any amount not withdrawn as required. For taxable years beginning after January 1, 2023, this penalty is 25% of the amount that should have been withdrawn. If the RMD shortfall is corrected promptly, the penalty may be reduced to 10%.

It is important to note that Roth IRAs are generally exempt from RMDs for the original account owner during their lifetime. This allows Roth IRA assets to continue growing tax-free for an indefinite period. However, beneficiaries of inherited Roth IRAs are subject to RMD rules.