You worked hard to earn your money and deserve to enjoy your retirement income, and when deriving income from investments, possibly a pension, and Social Security, there are many factors that will impact your taxes. And, if you have taxable, tax-deferred, and tax-free accounts, you will have the additional flexibility to manage your income. Therefore, when withdrawing from each account, thoughtful planning should be considered as there are no hard and fast rules on which to use first.
Taxable Accounts – Most dividends and fixed-income investments as well as gains from selling securities less than 12 months will generally be taxed at ordinary income tax rates. But for qualified dividends and gains from the sale of securities held for more than 12 months, those are taxed at capital gains rates, which are lower than ordinary income tax rates.
Tax-deferred Accounts – During your working years, you had the opportunity to contribute to qualified retirement accounts, such as 401(k), 403(b) and IRAs, and postponed paying income tax. The money was able to grow tax deferred, however these are not permanent tax shelters, as you need to pay ordinary income taxes when you begin taking required minimum distributions (RMD). But chances are you retired in a lower tax bracket, thus retaining more of your nest egg.
If you still have company stock held in a tax-deferred employer-sponsored retirement plan, such as a 401(k), the IRS provides more favorable tax treatment for those shares, so this would be a good reason not to rollover your 401(k) into an IRA as you would forego the special tax benefit.
Tax-free Accounts – If you contributed to a Roth IRA, Roth 401(k), or a Health Savings Account (HSA), the qualified distributions are tax-free and will not impact your Social Security taxes and Medicare premiums.
Retirement Account Conversions – If you have sizeable balances in your retirement accounts or believe that Congress will not extend the reduced tax rates enacted through the Tax Cuts & Job Act (due to expire at the end of 2025), then you may benefit from converting some of your tax-deferred accounts using the Roth conversion strategy to help mitigate higher tax rates later in life.
Tax-efficient Investments – During your retirement income years, it may make sense to adjust your portfolio to take advantage of more tax-efficient investments. Municipal bonds are very tax efficient because they do not incur federal taxes, and often the interest income is tax-exempt at the state and local level. Treasury bonds provide tax efficiency as they are exempt from state and local income taxes. Among stock funds, exchange traded funds (ETF) tend to be more tax efficient than mutual funds as they have fewer in-fund capital gains events.
Social Security and Medicare – Depending upon your combined income and tax filing status, up to 85% of your Social Security benefits are federally taxable. Combined income is the sum of your adjusted gross income (AGI), tax-exempt interest, and 50% of Social Security benefits received.
If you experienced a cash windfall, like from an inheritance, although you may not have paid tax on that income, your Medicare premiums will likely go up this year, sometimes doubling or tripling. Keep in mind that Medicare premiums are based on your modified adjusted gross income (MAGI) from two years prior.
Extra Deduction for Seniors – If you are age 65 or older, you are eligible for an additional tax deduction when using the standard deduction on your income tax return.
State Income Tax – The majority of states have an income tax, so there may be advantages to relocating to one of nine states that have no state income tax to help reduce your retirement income tax burden. Also, some states will tax your pension or annuity benefits, so you will want to consider how that impacts your income situation.