This years’ tax filing extension to May 17th might have you thinking about taxes longer than usual. We think about tax-efficiency all year long, especially for clients who are nearing or are in retirement.
During retirement, income is typically drawn from several sources, such as retirement accounts, taxable investment accounts, and Social Security benefits. Each of these sources is taxed according to its own rules. To appropriately plan for your retirement, it is important to be aware of what these rules are, whether (and when) you are required to make withdrawals, and how paying taxes on distributions will impact your overall financial goals. Following is a brief overview of the most commons sources of retirement income and how they are taxed.
Traditional IRA and Traditional 401(k)
Withdrawals from traditional tax-deferred retirement accounts are taxed at your normal income tax rate. Once you reach a certain age, you must start taking—and paying taxes on—required minimum distributions (RMDs). The IRS changed the RMD rules in 2020. If you reached age 70½ in 2019, you would have taken your first RMD by April 1, 2020. If you are age 70½ in 2020 or later, you are required to take your first RMD by April 1 of the year following the year you turn 72.
Because contributions to Roth IRAs are made with after-tax money, withdrawals from these accounts are tax-free. You can withdraw contributions to your Roth account at any age. However, withdrawals on earnings before age 59 ½ are subject to early withdrawal penalties. Roth IRAs do not have RMDs like traditional IRAs, so your money can continue growing in the account.
Profits from the sale of stocks, bonds, and other investments outside of tax-advantaged retirement accounts are taxed at capital gains rates, which vary depending on how long you have owned the investments. Short-term capital gains are taxed as ordinary income and apply to investments you have owned for one year or less. Long-term investments, those held for more than a year before selling, are subject to preferential long-term capital gains rates of 0%, 15%, or 20%, depending on your tax bracket.
Creating a Withdrawal Plan
Again, the above presents a broad-brush overview. There is a myriad of regulations and many factors to consider as every situation is unique. For instance, what impact will income have on Social Security benefits? Would Roth conversions make sense for me?
A careful withdrawal plan coordinated with your tax advisor and estate attorney as applicable can help maximize your investment returns while minimizing the taxes you owe to best support you during your retirement years.