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Taxes and Retirement - Part 1

Taxes and Retirement - Part 1

| February 07, 2024

This month, we’re continuing our in-depth discussion of retirement with a look at the effects taxes can have on your retirement savings. During your retirement years, unlike your working years, it is your responsibility to make sure taxes are paid on the sources you use for retirement income. However, in some cases your retirement income may actually be larger than your pre-retirement income and you will likely have fewer reductions that can lower your taxes. That is why I encourage clients to create a retirement income withdrawal strategy that puts them in the lowest possible tax bracket. This is one of the best ways to help manage tax impact in retirement.

This week we will look at common retirement accounts and how they are taxed. Typically, it is best to create a retirement income plan that uses funds from taxable accounts first which will allow assets in your tax-deferred accounts to continue to grow in a tax-advantaged manner. Let’s look at how common accounts used for retirement income are taxed.

One of the most common sources of retirement income is a 401(k) or 403(b), depending on whether you worked for a for-profit or non-profit company. When you made contributions to either of these plans during your working years, they were with pre-tax dollars. However, when you withdraw the funds as part of your retirement income plan the dollars will be taxed at your current tax bracket rate in retirement. 

IRAs are slightly trickier because there are three different types and they are all taxed differently. Traditional IRAs are funded with pre-tax dollars so your withdrawals are taxed at your current retirement tax rate. Whereas, Roth IRAs are funded with after-tax dollars, so your withdrawals are tax-free. Then there are Rollover IRAs which are funded with the assets in your workplace retirement plan, like a 401(k) or 403(b). As we said, those accounts are funded with pre-tax dollars which makes the withdrawals from your rollover accounts taxable at the ordinary income tax rate you are at in retirement.

It may surprise you to know that when it comes to Social Security income, you may owe taxes on that in retirement as well! That is why it is critical to know the provisional income threshold you are at so you can anticipate and prepare for a tax impact on your Social Security income.

If annuities are part of your retirement income plan you should know that they are taxed in different ways depending on how they were funded, similar to IRAs. If you made annoying contributions with pre-tax dollars they will be taxed at your ordinary income rate in retirement. However, if you made after-tax contributions a portion of your distributions, the part that the account earned while invested, will be taxed while the remainder will be tax-free.

If you are lucky enough to still get a pension when you retire, expect to pay ordinary income tax on your withdrawals as most pensions are funded with pre-tax dollars during your working years.

Join me next week when we discuss how RMDs or Required Minimum Distributions from certain retirement accounts may affect your tax bracket and ways to manage the impact.

Until next time…

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7 Tax-Free Investments to Consider for Your Portfolio - SmartAsset 

This material was created for educational and informational purposes only and is not intended as tax, legal or investment advice.