THE 8 WAYS TO GET INCOME IN RETIREMENT AND HOW THESE INCOME SOURCES ARE ALL TAXED DIFFERENTLY

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The 8 Ways to Get Income in Retirement and How They Are All Taxed Differently

What income sources are available to retirees? How are these income sources taxed? And how does taking from one source affect the tax rates on another source?

There are several possible sources for your retirement income, and many are taxed differently from each other. Some are taxed at capital gains tax rates, others at ordinary income tax rates, and others are not taxed at all. And still, social security is taxed differently. Beyond that, the amount of your taxable income from these sources affects other “taxes” like Medicare IRMAA premiums and the Net Investment Income tax for Obamacare.

For example,if you take more from your Traditional IRA now, then that can increase the amount of tax on your social security. But on the other hand, if you take more from your Traditional IRA now, that will likely lower your future Required Minimum Distributions. If you delay social security and take less from your Traditional IRAs for income, then you can convert more to a tax-free Roth now at lower rates than in the future when you will have more taxable income due to RMDs and social security. Another example is if you take less out of your Traditional IRA, then you could be in a lower capital gains tax bracket. But if you take out more from your Traditional IRA, then that could push your capital gains into a higher tax bracket, like going from 0% to 15%, or from 18.8% to 23.8%! All these income sources are taxed differently and affect each other in other ways. The many moving parts are where retirement planning finds its use case.

The 8 Sources for Retirement Income

1. Social Security– In many cases, it makes sense to delay social security until Age 70 because the government guarantees you an 8% increase per year if you do so. The stock market does not hold that guarantee. But, in other cases it might make sense to take social security early, before Required Minimum Distributions (RMDs) on Traditional IRAs and 401ks are required. For some, this allows a few years of receiving social security with none of it being taxed. Once RMDs kick in for them, then social security likely becomes taxable. For many, delaying social security to Age 70 vs. Full Retirement Age (FRA) has a breakeven age of 81-82, meaning: If you live past age 81 or 82, and you decided to delay SS until Age 70, then you made the right decision and received more from Uncle Sam vs. if you chose to file at FRA.

2. IRAs, 401ks, 403bs, workplace retirement plans– Most near retirees and retirees have built up their retirement savings via one of these types of retirement accounts. When these accounts are drawn on for retirement income, the distributions are fully taxed as ordinary income. Ordinary Income tax rates are higher than the capital gains tax rates, so perhaps it makes sense to take income from regular taxable brokerage accounts instead of your retirement accounts. Regardless, you will be required at some point to start withdrawing from these accounts and that is at your Required Minimum Distribution (RMD) Age.

3. Roth IRAs, Roth 401ks –Many people have strategically saved and invested inside a Roth account, which is tax-free when taken out in retirement. For many, it might make sense to draw from these accounts last, so that it has time to grow tax-free. But for others, it might make sense to draw on some of it now so that you reduce your overall tax liability today by remaining in lower ordinary income tax brackets, lower capital gains tax brackets, and lower Medicare Premium IRMAA brackets. It might also make sense to draw on a Roth for income to reduce the taxes on your Social Security. To build these Roth IRAs, many strategies are available such as regular contributions, backdoor contributions, converting Traditional IRA monies into the Roth, and in—plan 401k Roth Conversions.

4. Regular, Taxable, “Brokerage” accounts –These accounts are what you have invested in outside of your workplace retirement plans, Roth and regular IRAs. Some are titled individually TOD, or JTWROS, or in a trust’s name. The lower, capital gains tax applies to these accounts and is why it might be better to draw your income from these accounts instead of from the higher, ordinary income taxed Traditional IRAs. If you have regularly tax loss harvested, then you could potentially sell positions, realize gains, and have no tax liability. Furthermore, if you are Married Filing Jointly with taxable income under $94,050, then you could realize gains in the 0% capital gains tax bracket. Doing this could also reduce the amount of your social security that is taxed.

5. Checking/Savings Accounts –For many with built up savings accounts over the years, it might make sense to draw on these accounts in certain years in order to keep taxes down on other income sources. For example, if you are making a Roth conversion this year, then in order to keep overall taxes down, you might suspend withdrawals from a Traditional IRA and instead take your income from your savings account, where the taxes are minimal and limited to interest earned.

6. Pensions and Lump Sum Pensions –Most pensions are taxed at ordinary income tax rates, just like workplace retirement plans and regular IRAs. If you elect the lump sum pension payout to you directly, then you would owe the total ordinary income tax on it that year. And if you do this, then it could bump you up to much higher tax brackets. Therefore, it might make sense to do a lump sum pension rollover into a regular IRA instead. That way you could spread out the taxes over many years at lower rates. You would also have control over how it was invested.

7. Annuities –Annuities are taxed differently depending on what sources were used to purchase it. If it was purchased with pre-tax funds, like a 401k or Traditional IRA, then the entire amount of the withdrawal is taxed at ordinary income rates. If it was purchased using after-tax money, like money from a bank account or regular brokerage account, then you’re normally only taxed on the annuities earnings.

8. Inheritances– Many people nearing or entering retirement inherit assets from their elderly parents. (Don’t be so hard on yourself 70 year olds -  “elderly” is now a term for those 85+ with lifespans increasing so much.) What you inherit matters big time.If you inherit:
   1. A regular investment account, then you receive a step up in basis and owe essentially zero capital gain taxes on it on the date of death (unless there are estate taxes, which is a different story). Therefore, this might be your chance to allocate some of it for “income” or spending. It’s also a good chance to reinvest the portfolio since no capital gains would be owed.
   2. A Traditional IRA, and you are a non-spouse, then you’ll likely have ten years to take it all out and each withdrawal/distribution is fully taxed at your ordinary income tax rates. So if you have your own Traditional IRA that you haven’t drawn on yet (not RMD age yet) and if you haven’t filed for social security yet, then it might make more sense to take out more of the inherited IRA now vs. later years. Or perhaps you take it out evenly over 10 years so you don’t have a huge chunk of taxable ordinary income in year ten that bumps you up into a much higher tax bracket.
   3. A Roth IRA, then you’ll likely have ten years to take it all out, but none of it will be taxable. It will all be tax-free, which is huge. So perhaps you wait until Year 10 to take it all out so you give it as long as possible to grow tax-free! Or, you might draw on it for previously discussed reasons in the Roth IRA section above.
   4. A property or home,then this is treated similarly to a regular investment account whereby the cost basis of the home is stepped up to fair market value on the date of death. Therefore, it might be prudent to sell the house so capital gains are owed. You could earmark the sale proceeds for a regular investment account, savings, spending, or a combination.

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