Taxes in Retirement

• Managing your taxes in retirement can be difficult due to different rules and regulations on various types of retirement income
• The standard retirement savings vehicles differ based on whether you pay taxes now (Roth), or later in retirement (Traditional)
• Other policies such as early withdrawal penalties, RMDs and QLACs are designed to make sure that your retirement savings go toward their intended goal: to provide you with income in retirement

Taxes in Retirement: The Basics

Entering retirement means a shift in where you receive income, from your salary to new sources such as Social Security, 401(k) and IRA withdrawals, pensions, and/or annuities. These sources all have different tax rules, including whether your income is taxed as capital gains or ordinary income, each with different tax rates. Rules also vary based on whether your retirement income is tax-deferred. Read on for a high-level overview of common tax structures for retirement savings. But, note that we are not tax advisors, and we advise you to consult yours before making any decisions.

Taxes in Retirement: Roth vs. Traditional IRA/401(k)

One of the first decisions you have to make when saving for retirement is whether to use the Traditional or Roth form of retirement savings accounts. This decision needs to be made for both individual retirement accounts (IRAs), which are typically self-managed account that you sponsor yourself, and 401(k)s, which are typically self-managed accounts that are sponsored by your employer.  Both allow for you to make contributions to a Roth account (pay taxes now) and/or a Traditional account (pay taxes later), assuming your employer has a Roth 401(k) option. In a Roth, you place some of your post-tax income in a retirement portfolio, and then withdraw your contributions and accumulated interest tax-free in retirement. In a Traditional account, you defer paying income taxes on your retirement contributions until you take withdrawals in retirement. Your withdrawals are then taxed as ordinary income, including both your contributions and any accumulated interest.

How do you decide whether to opt for Roth or Traditional status? Really, the decision is based on your outlook on your own taxes:

• If you believe that your taxes will be lower in retirement than they are now (factoring in both the overall tax rates and your tax bracket), then you’re better off delaying paying taxes until retirement. That’s achieved through a Traditional IRA/401(k).
• If, on the other hand, you believe your taxes will be higher in retirement than they are now, you’re better off paying taxes now. That’s achieved through a Roth IRA/401(k).

(Note that contributions to a Roth IRA are limited by one’s income level, as explained here.)

Taxes in Retirement: Required Minimum Distributions (RMDs)

Traditional IRAs and 401(k)s require that you withdraw a certain amount of your retirement savings after you turn 72. The minimum distribution formula is determined by the IRS (read more about RMDs here), but generally require you to divide your account balance over a life expectancy factor. Roth IRAs/401(k)s  are exempt from RMDs because the government has already received their taxes on that money. Aside from Qualified Longevity Annuity Contracts (QLACs), which we will delve into later, longevity annuities purchased with Traditional IRA or 401(k) rollover money are also subject to RMDs, meaning that you have to start your annuity income by 72.

To calculate your RMD in retirement, consult our calculator here. To learn more about longevity annuities, head to this article.

Taxes in Retirement: Qualified Longevity Annuity Contracts (QLACs)

The QLAC was created in July 2014 when the U.S. Treasury amended the Internal Revenue Code’s required minimum distribution (RMD) rule. A QLAC is a longevity annuity purchased using your qualified retirement savings, such as from a Traditional IRA or 401(k) rollover, with income starting as late as 85. By transferring money (up to $135,000 allowed) out of your qualified pre-tax retirement savings plan and into a QLAC, you reduce the balance of your assets subject to the RMD calculation.   

To learn more about QLACs, head to this article. To learn more about QLACs and RMDs, head to this article.

Taxes in Retirement: Early Withdrawal Penalties

Early withdrawal penalties on retirement savings are intended to reduce leakages, or withdrawals from retirement savings for non-retirement purposes, by imposing penalties on withdrawing money prior to the retirement age. Via the IRS: “Generally, early withdrawal from an Individual Retirement Account (IRA) prior to age 59½ is subject to being included in gross income plus a 10 percent additional tax penalty.” Exemptions to early withdrawal penalties exist in circumstances such as job loss, education or medical hardships. Exemptions are not uniform across retirement accounts, with noticeable differences between qualified plans and IRAs (learn more here).

Taxes in Retirement: Purchasing an Annuity

When purchasing an annuity, you have the option of using retirement or non-retirement savings, called qualified or non-qualified, respectively. You can purchase an annuity via a rollover from your 401(k), Traditional IRA, or another qualified plan. The money is transferred penalty and tax-free from one plan to the other, and the annuity will maintain the same tax status, whether Traditional or Roth, as the source of funds.

Non-qualified annuities are purchased with post-tax money, and a portion of the income in retirement will be taxable. Each income payment for non-qualified annuities can be split into two pieces: a part that’s returning your initial premium, and a part that the insurance company determines (based on IRS rules) is your projected gain or interest earned. In this case, you are not taxed on the principal that is returned to you, however, income received in excess of your principal is taxable as ordinary income. The insurance company determines the ratio of annuity income that is considered returning principal, which is not taxed, and interest payment, which is taxable. Once your principal has been fully returned, all future payments are taxed as ordinary income.

To learn more about taxes on immediate annuities, head to this article. To learn more about taxes on longevity annuities, head to this article.

Taxes in Retirement: Ordinary Income Taxes and Capital Gains Taxes

Retirement income (Social Security, pensions, and 401(k)/IRA distributions) are generally taxed as ordinary income. Your tax rate on ordinary income is dependent on a host of factors, including your cumulative amount of taxable income that year, state and local tax rates, and any applicable deductions.

Money earned on investments inside a non-retirement account, such as a brokerage account, is generally taxed as capital gains. The capital gains tax rate depends on the length of time that you have held the investment, with short-term capital gains rates being higher than long-term capital gains rates.

To learn more about taxes on retirement income, head to this article.

Taxes in Retirement: Summary

In summary, whether you pay taxes now or in retirement is determined by the type of vehicle you choose. With the Roth status, you pay taxes now. With the Traditional status, you pay taxes in retirement. The taxes you pay on money from qualified retirement accounts are generally determined using ordinary income tax rates. On the other hand, taxes paid on earnings from non-retirement accounts use capital gains tax rates.

Policies such as early withdrawal penalties, RMDs, and QLACs are designed to make sure that your retirement savings go toward their intended goal: to provide you with income in retirement. This article serves as a good first step by providing a high-level taxes in retirement and how they apply to annuities, now take the next step by consulting our online resources to learn more about annuities.

Blueprint Income is not a tax advisor and we encourage you to speak with your tax professional about the potential tax ramifications the sources of your retirement income.