The way you withdraw your pension affects your tax brackets. This can be quite a complicated issue. Depending on which plans you have, your retirement withdrawals may be considered taxable income, taxable capital gains, or untaxed income. For each taxable segment of your withdrawals, the amount you receive determines your taxable income and therefore your tax bracket. Planning this is part of a smart pension strategy. Here’s what you need to know.
If you need help planning your withdrawals, a financial advisor can help you develop a retirement strategy.
Categories of Taxes That Can Cause Retirement Bills
One of the most important things to consider when planning for retirement is your taxes. And Graham Ortmann, a CPA at financial education company Zogo, told SmartAsset in an interview that in addition to one-time events like selling your home or moving, you need to know if and when you need to pay taxes on your retirement plans.
“Withdrawals from different types of retirement accounts can also affect your taxable income,” he said. “For example, qualified Roth withdrawals are not taxable, while withdrawals from traditional 401(k) funds or IRAs would be.”
In general, there are three categories of pension withdrawals you can take:
Untaxed
Roth-style accounts are known as after-tax retirement accounts. You pay tax on the money you deposit and do not receive any benefits during your working years. When you retire, you can then withdraw this money tax-free, meaning you pay nothing on the portfolio gains.
It’s usually a good idea to maximize your after-tax accounts first as part of retirement planning, as this saves most people much more money than a pre-tax account.
If you withdraw money from a tax-free account, your tax status will not change. This money does not contribute to your taxable income for the year and thus does not affect the tax bracket of other withdrawals or income.
Just income
Withdrawals from pre-tax retirement plans, such as 401(k) and IRA accounts, are taxed as ordinary income. This rule applies even if you make withdrawals based on the sale of stocks or other assets that would normally constitute capital gains. This money is applied to your taxable income for the year and affects your income tax bracket.
Added values
Most, if not all, tax-advantaged retirement accounts do not incur capital gains taxes. Instead, withdrawals are treated as ordinary income (if made from a pre-tax account) or untaxed income (if made from an after-tax account).
However, withdrawals from a standard portfolio without specialized tax benefits can lead to capital gains based on the nature of your returns. Normally, actions such as selling stocks or bonds from a standard portfolio apply to your capital gains tax bracket for the year.
A financial advisor can help you draw up a tax-efficient retirement strategy. Make a match with a financial advisor today.
Withdrawals determine your taxable income
“To best plan your tax situation, you should think about your expected sources of income and deductions and whether you expect to be in a higher or lower bracket than you are now,” says Ortmann. “If you fall into a higher category, consider investments and accounts that offer tax-free or tax-advantaged withdrawals. If you’re in a lower tax bracket, you may want to consider investments and accounts that can lower your tax liability in the present.
In a sense, your tax bracket during your retirement works exactly the same as it does during your working life. The more money you withdraw from a pre-tax retirement account, the higher your income will be and the higher your income tax bracket. The more capital gains you generate from a non-beneficial investment portfolio, the higher your capital gains tax bracket.
Specific tax implications of withdrawals
Here are four important considerations to keep in mind regarding the tax implications of different types of income and capital gains:
Social Security
The first topic to consider is social security. Based on your tax status and household income for the year, the IRS can apply 0%, 50%, or 85% of your Social Security benefits to your taxable income for the year. This provides a baseline for your annual taxable income, since you must receive Social Security benefits beginning at age 70.
Suppose you are an individual with a household income of more than $34,000. You received $21,000 in Social Security benefits last year. The IRS would apply 85% of these benefits to your taxable income. This amounts to $17,850 in taxable benefits, which would put you in the 12% tax bracket in 2023.
A financial advisor can help you make calculations to determine what your retirement income and taxes might look like. Talk to a financial advisor today.
Tax-advantaged retirement accounts
You can ignore any withdrawals you make from an after-tax account, such as a Roth IRA or a Roth 401(k). Because these accounts generate tax-free income, withdrawals do not increase your taxable income for the year.
You would apply any withdrawals you make from a pre-tax account, such as a 401(k) or an IRA. The IRS considers this money to be ordinary income. You add this to your taxable Social Security benefits for the year as part of your total taxable income.
For example, let’s say you withdraw $50,000 from your 401(k) for the year. You also have the $17,850 in taxable Social Security benefits. Your taxable income is now $67,850, which would put you in the 22% tax bracket in 2023.
Taxable income
Finally, add in any other sources of taxable income for the year, such as money you earned from work or portfolio income without a tax benefit that counts as income. The final total is your total income for the year and determines your tax bracket.
For example, say you rent out a room on Airbnb that generates $5,000 per year in additional revenue. You would add this to your Social Security benefits and portfolio withdrawals for a total taxable income of $72,850. This still leaves you in the 22% tax bracket.
Added values
In addition to income, it’s also important to consider any capital gains taxes you owe during the year. These are generated from your private portfolio transactions, meaning any money you take out of a non-tax-advantaged investment account. You normally generate capital gains by selling financial assets such as shares, bonds and funds that you hold for more than twelve months. The amount you make from these sales determines your capital gains tax rate for the year and is separate from your income tax rate.
In short
If you withdraw money from a pre-tax retirement account, such as a 401(k) or an IRA, these withdrawals will apply to your income tax bracket for the year. Withdrawing money from an after-tax account, such as a Roth IRA or a Roth 401(k), will not increase your taxable income and thus does not apply to your income tax bracket. By managing how much money you withdraw and from which account, you can manage your taxes on an annual basis.
Tax planning tips for retirement
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A financial advisor can help you draw up a comprehensive retirement plan. Finding a financial advisor does not have to be difficult. SmartAsset’s free tool allows you to work with up to three vetted financial advisors serving your area, and you can schedule a free introductory meeting with your advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Tax planning really doesn’t stop at retirement. In fact, it is very important to have an effective strategy to make your withdrawals tax efficient.
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Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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