It’s true that the best part of planning your retirement usually circles around traveling, rounds of golf, and restaurant meals that you’re going to experience. I mean, why not? After all, you’ve totally earned it!
Besides that, maybe you’re planning on financially helping your children and grandkids, or even investing in something you’ve always been passionate about. Even so, lots of retirees don’t actually take into consideration the whole impact of federal and state income taxes when they withdraw money from their nest egg.
So almost any form of retirement income, whether it’s Social Security, 401(k), or traditional IRA, is taxed by the good ol’ Uncle Sam. So unless you happen to live in one of those nine states that don’t tax traditional income, you should expect your home state to call you in retirement too.
So do yourself a favor TODAY and take a look at these federal income taxes you might have to pay, depending on your retirement income:
Traditional IRAs and 401(k)s
Who doesn’t love tax-deferred retirement accounts such as 401(k)s and traditional IRAs? Any contribution to these plans will usually reduce their taxable income, and save them money on their tax bills the same year.
Their savings, dividend, and even investment gains within these accounts will continue to expand on a tax-deferred basis. However, what they might tend to forget is that the taxes will have to be paid at some point when they retire and begin withdrawing money and that those taxes will apply to their gains, their pretax, or even deductible contributions.
Even more, there’s gonna be a certain point where they’ll have to withdraw money from those accounts, and the required minimum distributions (RMDs) kick in at 72 years old for those holders who have traditional IRAs and 401(k).
Roth IRAs usually come with a bigger long-term tax advantage, and that is the fact that contributions to Roths aren’t actually deductible, but withdrawals are tax-free. There are two things worth remembering in this situation: you must have had a Roth IRA account for a minimum of five years before you take any tax-free withdrawals.
The five-year clock usually starts ticking the first time you deposit your money into any Roth IRA, and it happens either through a contribution or a conversion from a traditional IRA. Secondly, even if you withdraw the amount you contributed tax-free anytime you want, you should be at least 59 and a half years old, in order to be able to withdraw the gains and avoid a 10% early-withdrawal penalty.
At some point in the past, Social Security benefits were completely tax-free for everyone. But as we all know, that fairytale is long gone since 1983. For the majority of Social Security recipients, the benefits still aren’t taxed.
However, depending on the “provisional income”, others aren’t just as lucky and might have to pay federal income tax on up to 85 percent of their benefits. If you want to determine the provisional income, you should start with your adjusted gross income and then add half of your Social Security benefits and all your tax-exempt interest.
If you have a provisional income of less than $25,000 ($32,000 for those who are married and decide to file a joint return), your Social Security benefits are then completely tax-free. If you have a provisional income that’s around $25,000 and $34000, then up to 50% of your benefits will be taxable.
The majority of pensions are usually funded with pretax income, which basically means the full amount of your pension income will be taxable when you receive the funds. Payments that come from private and government pensions are taxable at an ordinary income rate, assuming that you made no after-tax contributions to that plan.
Sales of stocks, bonds, and mutual funds
If you deal with selling stocks, bonds, and mutual funds that you’ve kept for more than a year, the proceeds will be taxed at the long-term capital gains rates of 0%, 15%, and 20%. So take these figures and compare them to the top 37% tax rate on an ordinary income.
The 0%, 15%, and 20% rates on long-term capital gains are usually based on set income thresholds that, depending on inflation, can be adjusted. For 2022, the 0% rate applies to people that have a taxable income as high as $41,675 on single returns.
The 20% rate begins at $459,751 for those single filers, $488,501 for heads of households, and $517,201 for those who file together. The 15% rate is for those individuals with a taxable income between 0% and 20% breakpoints. These rates might apply also to qualified dividends.
Plus, there’s also a 3.8% surtax on net investment income, besides the 15% or 20% capital gains rate for those taxpayers who are single, which have an adjusted gross income of over $200,000, and for joint filers over $250,000.
This 3.8% extra tax is usually due to the smaller net investment income (NII) or even the excess of modified AGI over the $200,000 or $250,000 amounts. NII might also include dividends, taxable interest, passive rents, capital gains, annuities, royalties, and so on.
Lots of seniors own stocks, whether directly or through mutual friends. Dividends that are paid by companies to their stockholders can be treated for tax purposes either as qualified or non-qualified. Qualified dividends can be taxed at long-term capital gains scores.
Non-qualified dividends could be taxed at ordinary income tax rates. Shareholders usually have to hold stock for a certain period of time, in order to take advantage of the capital gain rates on dividend payments.
As an example, dividends that are paid on the shared stock have to be held for more than 60 days within the window beginning 60 days before and ending 60 days after the date the company has declared dividend payment.
There is a very good chance that some of the income you get from any annuity you own is taxable. If you got an annuity that is providing income in retirement, then the portion of the payment that is representing your principal is tax-free, the rest is taxable.
As an example, if you bought an annuity for $150,000 and it is worth $225,000 in 10 years, you could only pay tax on the $75,000 of earned interest. The company from which you bought the annuity from is obliged to tell you what is taxable.
However, different rules might apply if you buy the annuity with pretax funds, like a traditional IRA. In this case, 100% of your payment could be taxed as ordinary income. Plus, be aware that you will have to pay any other taxes that you owe on the annuity at any ordinary income tax rate, not the preferable capital gains rate.
Municipal bond interest is completely exempt from federal tax.
On the same note, interest from bonds issued in an investor’s home state is usually exempt from state income taxes. BUT, be sure to check your state’s laws. However, keep in mind that capital gains might be subject to federal tax if you sell municipal bonds.
CDs, Money Market Accounts, Savings Accounts, and Corporate Bonds
Ordinary income tax rates might apply to interest payments on different certificates of deposit, savings accounts, money market accounts, and even corporate bonds. Capital gains rates will apply when you sell corporate or even municipal bonds.
For federal income tax purposes, interest on EE and I U.S. savings bonds could be taxable at ordinary income rates in the same year the instruments mature or when they are completely redeemed, depending on which one’s earlier.
Holders of any HH bonds report and pay U.S. tax on interest every year as it’s paid to them. Interest on any U.S. savings bonds is exempt depending on the state and local income taxes. So if you are about to return to school in your golden years, know that interest on EE and I bonds that you might use to pay for higher education might be tax-free but provided certain rules are followed.
The bonds must have been bought after 1989 by buyers who were 24 years or older.
They could also be redeemed to pay for college, graduate school, or even vocational school tuition and fees for the bondholder or their spouse or dependent. Room and board costs aren’t considered eligible.
On the other side, bonds must be in the taxpayer’s name. Grandparents aren’t able to use this tax break to help pay for their grandchild’s college tuition, except the grandparent can whether on his or her federal tax return, claim the grandkid as a dependent.
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