Your retirement income likely will come from a variety of sources. For example, there are Social Security as well as brokerage accounts, employer-sponsored retirement plans, traditional and Roth IRAs, and tax-deferred annuities, among other possibilities. With so many choices at your disposal, you’ll need to decide when to tap each of those sources, and taxes will be one key factor in making those decisions.
The conventional wisdom is to withdraw funds from taxable accounts early in retirement in order to preserve tax-sheltered assets for as long as possible, letting the funds continue to grow without being eroded by current taxes. But that’s not a hard and fast rule. You’ll need to come up with a balanced approach which factors in all of your personal circumstances, including your tax situation. Here are tax considerations for several potential income sources:
Brokerage accounts. Because these investment accounts aren’t tax-deferred, how they’re taxed depends on particular assets. Stock dividends and bond interest will be taxed when you receive them. If you sell stocks to raise cash, the sale will be taxed as a short- or long-term capital gain depending on how long you’ve held the shares. If you’ve owned them for more than a year, they’ll be considered long term and taxed at a preferential rate of 15% for most investors and 20% for those in the highest (39.6%) tax bracket for ordinary income. Short-term gains are taxed as ordinary income. In addition, you might be liable for a 3.8% Medicare surtax that applies to the lesser of your “net investment income” (capital gains, dividends, and other investment-related income) and the amount by which your modified adjusted gross income (MAGI) exceeds $200,000 for single filers and $250,000 for joint filers. Capital gains from brokerage accounts could trigger or increase liability for the 3.8% surtax.
Employer-sponsored retirement plans. Most distributions from “qualified” retirement plans, such as 401(k)s and 403(b)s, are taxed at ordinary income rates. That rule applies to the part of your withdrawal representing pre-tax contributions and earnings (often the entire amount). Although such distributions aren’t considered net investment income for calculating the 3.8% surtax, they do increase your MAGI and could make you liable for that extra tax.
Traditional IRAs. Like your withdrawals from employer-sponsored retirement plans, distributions from a traditional IRA are taxed at ordinary income rates on a pro-rata basis. In other words, the portion representing deductible contributions and earnings is considered taxable income, but there’s no tax on nondeductible contributions you may have made to the account.
Roth IRAs. The tax treatment for Roth IRAs is significantly different. For a Roth account you’ve had for at least five years, most distributions are completely exempt from federal income tax. That applies to withdrawals you make after age 59½ as well as those made because of death or disability or to cover first-time homebuyer expenses (up to a lifetime limit of $10,000). And you can convert a traditional IRA to Roth status, although the tax-deferred amount you convert will be taxed at ordinary income rates.
Tax-deferred annuities. As the name implies, these income-producing insurance products are exempt from tax until you begin taking distributions. Then, if you take a lump sum payout from a nonqualified annuity, you’ll owe ordinary income tax on the difference between the amount you paid into the annuity and its value when you receive the payment. But you also could choose “annuitized” payments that may continue for as long as you live. In that case, only the portion of the payment representing earnings in the annuity account is taxable. Taxation of variable annuities, whose payouts are based on investment earnings, is more complex, so be sure to get advice from your tax professional about such distributions. Finally, payments aren’t considered investment income for the purpose of computing the 3.8% Medicare surtax but the portion that counts as income will increase your MAGI.
There are a few additional tax considerations you’ll need to take into account. Most distributions from tax-sheltered accounts before age 59½ will be hit with a 10% tax penalty, on top of the regular income tax, unless a special exception applies. Also, you are generally required to begin taking “required minimum distributions” (RMDs) from employer-sponsored plans, traditional IRAs, and tax-deferred annuities after age 70 ½, but there are no lifetime RMDs for a Roth IRA.