Anyone receiving a regular paycheck is familiar with income tax since it usually appears between the “gross” and “net” income of your pay stubs. In retirement, you will likely have many sources of “retirement income”, and consequently incur “retirement income tax”. In this post, we discuss some typical sources of retirement income tax, and how they interact with one another.
Note: This post has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
Guaranteed Retirement Income
Social Security is one of the most common sources of retirement income. It adjusts for inflation each year, so this benefit rises with the cost of living. Another less common source of guaranteed retirement income is a pension. These guaranteed income sources often give the retiree the choice to decide when benefits begin. They also may allow a deferral of benefits until a later age.
Now, if your total income is sufficiently low, pension and social security income could yield no tax liability. Otherwise, retirees incur tax on this guaranteed income as ordinary income.
Dividends, Interest and Coupon Payments
If you have a savings or taxable brokerage account with stocks, bonds, ETFs, mutual funds or other interest bearing investments, you may receive regular payments. As we discussed in our previous post on taxation, these payments are either taxed as ordinary income or capital gains.
Your “Nest Egg” Accounts
Individual Retirement Accounts (IRAs), 401(k)s, 403(b)s and 457 plans all provide tax-deferred growth. Since we usually fund these accounts with pre-tax money, the IRS taxes qualified distributions as ordinary income. Alternatively, we fund Roth IRAs, Roth 401(k)s and Roth 403(b)s with after-tax money, so we receive qualified distributions tax free. Lastly, if we sell stock or bond ETFs for a gain within a taxable brokerage account that were held for more than one year, taxes incurred are usually at the preferred capital gains rates.
Big Picture
All these sources may sound confusing, and may not apply to all retirees. But, putting these retirement income sources into a conceptual model can help you better understand how they affect a retiree’s annual tax liability. In the model below, we assume that all taxable brokerage accounts have a mix of dividend paying stock and bond ETFs. We show capital gains and qualified dividends above sources of ordinary income, since more ordinary income can push capital gain tax rates to higher brackets.
Using your nest egg efficiently can significantly improve both portfolio longevity and funds bequeathed to your heirs. Based on award winning research, we implemented this model into a free web application. We update the model’s algorithms regularly, so please try out this tool and send us your feedback on features you may want included in the future!
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