Not all retirement income is taxed the same. We explore five types of retirement income and how the federal government taxes them.
Traditional IRAs and 401(k)s
Traditional IRAs and 401(k) plans are tax-deferred accounts, meaning you’ve never paid taxes on the money. Contributions generally reduce taxable income in the current year, and the savings, dividends, and investment gains within the account grow tax-deferred.
When you start taking withdrawals from these accounts, you will pay federal income tax at ordinary income tax rates. This applies to gains and your pretax or deductible contribution. There is a 10% penalty for most payouts before age 59 ½.
You can delay withdrawals but can’t avoid the taxable income forever. These accounts are subject to required minimum distributions or RMDs. The federal government sets the age at which you must start taking these distributions and the amount you are required to take out. Currently, RMDs kick in at age 73. Prior to 2023, the RMD age was 72. If you turned 72 in 2022, you must take your first RMD by April 1st, 2023.
If you are 73 and still working, you can delay RMDs from your current employer-sponsored 401(k) until retirement as long as you don’t own more than 5% of the company.
The amount you must take out is determined by dividing the value of your retirement account by an IRS life expectancy factor.
Roth IRAs and Roth 401(k)s
Qualified distributions from a Roth IRA are tax-free. You must have held the Roth IRA account for at least five years and be 59 ½ or older to withdraw gains without a 10% penalty. The tax-free withdrawal applies to money deposited into a Roth IRA or Roth conversion. A Roth conversion is when funds from a traditional IRA or 401(k) are rolled into a Roth IRA.
Similar rules apply to the Roth 401(k). Withdrawals are tax-free as long as five years have passed since your first contribution. Currently, RMDs do apply to the Roth 401(k), however similar to the pre-tax 401(k)s, if you are 73 and still working, you can delay RMDs from your current employer-sponsored Roth 401(k) until retirement as long as you don’t own more than 5% of the company. Those turning 73 in 2023 have until April 1st, 2024, to take their first RMD. Starting in 2024, there will be no RMDs on Roth 401(k)s thanks to SECURE Act 2.0 legislation.
Roth accounts are powerful in retirement. Not only are qualified distributions tax-free, they also are not subject to RMDs (starting in 2024 for the Roth 401(k)). This gives you more control of this retirement income and the ability to reduce your taxable income in retirement.
The amount of federal tax you pay on your Social Security benefit is determined by your provisional income. Some Social Security beneficiaries will pay nothing, while others may have to pay federal income tax on up to 85% of their benefit.
If your provisional income is less than $25,000 ($32,000 for a married couple filing jointly), your Social Security benefit is tax-free. If your provisional income is between $25,000 and $34,000 ($32,000 and $44,000 for a married couple filing jointly), up to 50% of your benefit is taxable. If your provisional income is more than $34,000 ($44,000 for joint filers), up to 85% of your benefit is taxable.
Provisional income is determined by adding your adjusted gross income plus 50% of your Social Security benefit plus any tax-exempt income you received for the year.
Sales of Stocks, Bonds, and Mutual Funds
If you sell stocks, bonds, or mutual funds that you’ve held for over a year, the proceeds are taxed at a long-term capital gains rate of 0%, 15%, or 20%. The higher your income, the more you will have to pay in capital gains taxes.
For 2023, you may qualify for the 0% long-term capital gains rate with taxable income of $44,625 or less for single filers and $89,250 or less for married couples filing jointly. You qualify for the 15% long-term capital gains rate with taxable income of $44,626 to $492,300 for single filers and $89,251 to $553,850 for those who are married and filing jointly. The 20% rate applies to single filers with a taxable income of $492,301 or more and $553,851 or more for those who are married-filing jointly.
A home is often one of your most valuable assets. If you have owned the property and used it as your personal residence for at least two out of the five years before the sale, you can exclude up to $250,000 of the gain from income ($500,000 for married couples filing jointly). Any gains in excess of $250,000 for singles or $500,000 for a married couple will be taxed at long-term capital gains rates.
Gains from the sale of a vacation home are different. They do not qualify for the $250,000/$500,000 exclusion. Your gain is subject to long-term capital gains tax rates of 0%, 15%, or 20%, depending on your income.
Your Merkle Plan takes into account your retirement income sources, investments, and long-term tax plan. It includes a plan to spend and invest these assets in a way that is not only tax efficient but allows you to live out your retirement vision. If you have any questions about your tax plan or any of the components of Your Merkle Plan, please don’t hesitate to reach out to us.
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