As if retirement planning isn’t already hard enough, enter income tax planning. Ideally, the two should go hand in hand, but that’s not always the case. When it comes to withdrawing from your investments, I can think of a number of different taxes that may impact your retirement, your investments, your deductions, and ultimately your income.
In fact, understanding the tax ramifications of your withdrawals may be the difference between a successful retirement and an unsuccessful one. Or a retirement at age 62 versus age 65.
Furthermore, the taxability of your retirement income and your investments has the potential to significantly impact how much you should save for retirement, or how much you should spend. In fact, I could argue that a retirement portfolio of $1,375,000 may actually be equal in value to one worth $1,000,000.
How is that possible you ask? It’s simple. Depending on the type of investments you have and the type of income you earn, you may find yourself in a substantially different tax situation.
A good place to start the tax discussion is with an exploration of how your investments will be taxed in retirement.
Taxed as Ordinary Income
As defined by Wikipedia, ordinary income is generally income other than (long-term) capital gains income. Ordinary income is generally taxed at your marginal tax rate, based upon the tax schedules set forth by the IRS.
Ordinary income tax rates are generally the least favorable tax rates you can incur. Being the least favorable to the retiree, it would make sense to try to avoid ordinary income in favor of a more beneficial tax rate. However, retirees may often find themselves with some or all of their income being taxed as ordinary income in retirement.
Specifically, several types of investment income will be taxed as ordinary income:
401(k)s and IRAs
One of the more common methods of saving for retirement is an employer sponsored 401(k) or a personally established IRA. Typically, the majority (if not all) of the money in 401(k)s and IRAs is pre-tax money.
In addition to your contributions to a 401(k) and/or IRA being pre-tax, your earnings in the account grow tax deferred. During this accumulation period, zero tax is paid on the contributions and the growth.
As distributions occur from the tax deferred 401(k) and IRA, 100% of the withdrawal (again, assuming all pre-tax contributions) will be taxed as ordinary income.
Interest income, commonly, the interest the bank pays you on your deposits, is taxable income. Interest income is taxed as ordinary income.
Other sources of interest income include most interest from bonds (fixed income). Income can be paid from individual bonds as well as bond funds.
Short-Term Capital Gains
Short-term capital gains are another source of income that will be taxed at the least favorable ordinary income rates. A short-term capital gain is a gain that arises from the sale of a capital asset (often a stock, bond, mutual fund, and/or ETF) within one year of the purchase date.
For a hypothetical example, assume you buy a mutual fund for $100,000 on January 1st and subsequently sell this mutual fund for $120,000 prior to the end of the year. When you sell, you realize a $20,000 gain. This realized gain is a taxable transaction that will be included on your tax return.
Because the gain is short-term in nature (less than one year), the IRS taxes this gain as ordinary income versus long-term income (as discussed below).
Tax Deferred Growth in an Annuity
When talking taxes, annuities can be a different animal all to themselves. The taxation of annuities may be especially complicated with non-IRA annuities (discussed below). On the other hand, if you have an annuity that is an IRA, withdrawals are taxed as ordinary income as mentioned above in the 401(k)/IRA section.
It is possible, however, to take after-tax money and place it into an annuity. Earnings in a non-IRA annuity grow tax deferred, meaning you don’t pay tax on the earnings until they are withdrawn from the annuity contract. When you do withdraw from a non-IRA annuity, the earnings portion of the annuity value comes out first. This earnings portion is taxed at ordinary income rates.
Using the same hypothetical example from above, let’s assume you place $100,000 into an annuity and it grows to $120,000. As the annuity value increases, zero taxes are due. Upon taking a distribution, taxes will be due. In this example, the first $20,000 (the earnings) will be taxed as ordinary income. After the earnings are withdrawn you will begin to receive back your contributions to the contract. Withdrawal of contributions (also known as basis) is a tax-free return of your own money.
It is also possible to annuitize an annuity. When you annuitize an annuity, you give up your rights to a lump sum of money in exchange for a series of payments, often over a lifetime. From a tax standpoint, when you annuitize a non-IRA annuity, a portion of the payment you receive will be considered a tax-free return of your contributions to the contract and a portion will be considered earnings. In this example, the return of your contributions is non-taxable and the earnings portion is taxed as ordinary income. Upon receipt of your total contributions to the annuity, the full amount of the payment becomes taxable as ordinary income.
Some investments can provide for tax-free income in retirement. Tax-free income in retirement is clearly the most favorable. Not only will your distribution go further (would you rather have $50,000 tax-free or $50,000 that is taxable?), but tax-free income may keep your taxable income lower on your tax return. Combined with strategic planning, a lower taxable income may lead to opportunities, including less of your Social Security being taxable, ROTH conversions, and lower required minimum distributions.
Tax-free income may come from the following:
ROTH 401(k)s and ROTH IRAs
When money is withdrawn from a ROTH IRA or ROTH 401(k), the money withdrawn (both contributions and earnings) is tax free. Tax-free income means you will receive 100% of the amount withdrawn and zero dollars from this withdrawal will need to be included on your tax return.
When you contribute to a ROTH, you do so with after-tax contributions. The money going into the ROTH is taxed in the year you make the contribution. In essence, in making a ROTH contribution, you choose to forego a tax deduction (and tax savings) in the year of contribution in order to reap the benefits of tax-deferred growth and tax-free income (401(k) and IRAs lower your income in the year of contribution and produce an immediate tax saving) upon withdrawal
The advantage of a ROTH is on the back end. Because taxes are paid on the contributions at the time the contributions are made, withdrawals from a ROTH IRA are tax free. (Subject to minimal conditions).
Return of Basis from an Annuity
As mentioned earlier, it is possible to contribute after-tax dollars to an annuity. The earnings portion of an annuity, if any, would be withdrawn first. After the earnings have been withdrawn, the remaining annuity value is a tax-free return of basis.
In retirement planning, it is important to track if and when the earnings portion of the contract is withdrawn.
Tax-Free Income from Insurance
If designed, funded, and implemented appropriately, permanent insurance has the ability to produce tax-free income in retirement.
Rules regarding a withdrawal from a permanent insurance policy may allow the owner to withdraw contributions to the policy first. By withdrawing your contributions, you are in receipt of your own money. Because you are getting your own money back, you would not be taxed again on that money .
Once your contributions to the policy have been exhausted, it’s possible to take out a loan against the policy. Loans from a permanent insurance policy, like a return of your contributions, are tax free.
While tax-free income is possible with permanent insurance, I encourage you to work with an insurance expert on the specifics. If not designed appropriately and/or not withdrawn from correctly, you may find yourself with a lapsed or terminated policy which could cost you thousands in taxable income!
Long-Term Capital Gains and Qualified Dividends
A third type of retirement income is long-term capital gains. Long-term capital gains are subject to more favorable tax rates that can range from 0% to 20%, depending on your income.
Long-term capital gains are generated from the sale of a capital asset, like a stock, bond, or mutual fund. A long-term capital gain is anything that is held for longer than one year. Following the original hypothetical example above, we have an asset purchased on January 1 for $100,000 that grows to $120,000. If we assume this asset is held for more than one year, after January 1 of the following year, the $20,000 is subject to long-term capital gains treatment.
Long-term capital gains are more favorable than ordinary income, but still less favorable than tax-free income. It’s equally important to know that long-term capital gains will increase your adjusted gross income. A higher adjusted gross income may affect other taxes, including the taxability of Social Security and your ability to itemize your deductions.
Why Do Taxes Matter to Your Retirement Plan?
Diversification is a common word used in investment management and financial planning. Diversification, in short, means not having all your eggs in one basket*.
Regarding retirement planning and retirement income generation, diversification also has its place. Diversification among different types of investment accounts may lead to significant tax planning opportunities.
With any retirement plan, understanding how your investments and your income(s) are taxed is critical when trying to answer two of the most common questions.
- Do I have enough to retire? and
- How much money can I spend in retirement?
A good financial planner, a good financial plan, and a good retirement income strategy should evaluate all the various tax implications and withdraws from accounts strategically to help minimize your tax and help maximize your total income.
*Diversification does not guarantee a profit or protect against a loss.Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts. None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation. Prior to age 59½, distributions from a Traditional IRA may be taken for certain reasons without incurring a 10 percent penalty on earnings. Roth IRAs are available only to single-filers making up to $95,000 or married couples making a combined maximum of $150,000 annually. Variable annuities are designed to be long-term investments and early withdrawals may be subject to tax penalties and charges.