There are several tax-free ways to save for retirement, but that doesn't mean that those savings will be free from tax when you begin to access them in retirement. If you're saving into a pension, 401(k), or IRA (individual retirement account), then the payments you receive in retirement could be subject to federal income tax. And in some cases, social security can also be taxed. It's essential to plan for any tax that you may have to pay on your retirement benefits. Let's break down which retirement benefits are taxable.
Is retirement income taxable?
The short answer is that it depends on what kind of retirement accounts you have. Most people will rely on a traditional IRA—referred to as a traditional 401(k) if the account is provided by your employer—for their income in retirement. Since your contributions to this type of account were taken before tax, you'll have to pay tax when you retire. Income from a traditional IRA is taxed as regular income.
You may have also saved money into a Roth IRA. Withdrawals from this type of account are not taxable because contributions were made with after-tax income. As long as the account is at least five years old, and the account owner is more than 59.5 years old, then you won't face tax on withdrawals. However, employer-matching contributions to a Roth 401(k), and any growth associated with the match, are subject to income tax when you begin taking distributions. This will be treated as regular income when it comes to paying tax.
Social security benefits can also be taxed in retirement. To work out whether you'll need to pay tax on these benefits, calculate your total income (excluding social security) and add any tax-free interest you receive. Finally, add half your social security benefit to the total.
If the total is between $25,000 and $34,000 and you're single, or if you're jointly filing and the total is between $32,000 and $44,000, then you can be taxed on up to 50 percent of your social security benefits. If the total is more than $34,000 for a single filer or $44,000 for a joint filer, you can be taxed on up to 85 percent of your benefits. Again, if you have to pay tax on your social security benefits, then it will be treated as regular income.
If you have investments such as stocks or bonds that are not held in a tax-advantaged account, then you will continue to pay short or long-term capital gains tax on any profits when you sell the asset, even after retirement. And, if you hold an annuity that was funded with after-tax dollars, then you are still subject to annuity tax on any gains.
How to lower taxes on retirement income
There are several ways to lower your tax bill when it comes to retirement, some of which apply even before you retire. First, avoid withdrawing any money from your traditional IRA before you're 59.5 years old. If you withdraw early, you'll have to pay tax and face a 10 percent early withdrawal penalty. You can only make penalty-free withdrawals before retirement age if you leave your job associated with the 401(k) at age 55 or older.
When you change jobs, avoid withdrawing money from your 401(k), as 20 percent will be withheld for income tax. You can avoid paying tax by directly transferring the money from your old 401(k) to the trustee of your new 401(k).
If you have cash on hand or are continuing to work after the traditional retirement age, you may wish to hold off on making withdrawals from your retirement accounts. However, after the age of 72, a minimum distribution becomes mandatory, and you can face substantial fees of 50 percent if you fail to withdraw.
Your first required minimum distribution will be due by April 1 of the year you turn 72. Your second must be taken by Dec. 31 each year. If you delay your first distribution until April, you'll have to take two in the same year, which could boost you into a higher tax bracket. Taking smaller distributions before you are required to can also help lower your tax bracket and reduce your lifetime tax bill.
Finally, retirees who are 70.5 years or older can donate up to $100,000 of their IRA savings directly to a qualified charity every year. In the case of retirees, these donations can help to meet all or part of the minimum distribution requirement.