A Three-Part Series on Making the Most of Your Retirement Dollars - Part II
In Part I of this three-part blog post, we explored what spending in retirement can look like, how much you could afford to comfortably spend once retired, and how to maintain balance and flexibility with your spending.
In this post, we’ll explore the different types of income you can expect to encounter in retirement and walk through how each of them is taxed and treated by the IRS.
Finally, in Part 3, we’ll uncover the most efficient ways to distribute your money and make it last longer through tax-focused planning and distribution strategies.
Helpful Pointer #1: Remember when it comes to money and investing, it’s not what you earn, it's what you get to keep (after taxes).
Understanding the Different Types of Retirement Income Sources and
How They’re Taxed
Taxes are by far one of the biggest threats to your retirement portfolio and are often misunderstood by most investors. After all, popular to contrary belief, one of the most celebrated retirement savings vehicles, a Traditional IRA or 401k, is really tax-inefficient when you think about it.
Why?
All of your distributions in retirement will be taxed at Ordinary Income levels. This means your retirement account is only worth about 75% of its total value, once you account for the money that is needed to pay for the taxes on distributions. Yikes!
Now don’t get me wrong, saving for retirement is the most important thing and one of the main benefits of the Traditional IRA and 401k is being able to defer paying taxes on your investment gains until retirement. So, however, you can save, do it!
But when it comes time to retirement and start taking the money out, the name of the game is not paying more than you need to in taxes. Thus, tax planning will play a crucial role in your overall retirement plan and when done correctly, will help you more effectively maximize your retirement income and lower your total lifetime tax bill.
Understanding how taxes will impact your future decisions regarding Medicare, Social Security, and which type of investment accounts to withdraw from first will be a valuable tool to help you navigate your retirement.
The three most common types of income I see produced by retirees are:
Ordinary Income
Capital Gains
Rental Income*
Technically Ordinary Income but with benefits like Depreciation
Each of the above types of income is treated differently by the IRS and knowing the differences between them can prove to be helpful in knowing how to go about structuring your retirement income strategy. When it comes to building out your retirement income plan, it pays to know where to take your first dollar from and how each of these types of income is treated by IRS.
Ordinary Income
By far the most common type of income in retirement is ordinary income, which includes:
Your Social Security benefits*
Pensions
Part-time or full-time employment wages
Distributions from your IRA such as Required Minimum Distributions (RMDs)
Ordinary Income Part I: Social Security
Social Security has its own special set of income limits and circumstances when it comes to determining how much of your benefit will be taxed.
For many Americans, Social Security accounts for roughly 40% of their retirement income. Taxation of your benefits will vary depending on how much of your total retirement income comes directly from Social Security.
For a deeper dive into all of the different strategies for maximizing your Social Security benefits, you can read more in my recent blog post titled, Smart Moves to Consider Before Claiming Social Security. Additionally, knowing how to use your Social Security benefits to optimize your overall retirement outlook using tax-efficient strategies will be further discussed in Part III.
For now, it’s important to remember that your Social Security benefits will be taxed as Ordinary Income and the amount of taxation will vary according to the below graph:
Ordinary Income Part II: Pensions, Wages, and IRA Distributions
The remaining income sources, like income from your pension, distributions from your IRA, Annuity, 401k account, or wages from a part-time job are all taxed as Ordinary Income.
To determine how much is taxed at what percentage, the Internal Revenue Service sets thresholds each year. Marginal tax rates will be determined by your tax-filing status (Single, Married Filing Jointly, etc) and where your total ordinary income falls within the respective brackets.
Check out the graph below.
Helpful Pointer #2: It is a common misconception that all of your income will be taxed entirely based on one entire marginal tax bracket.
Example: If you file as Single and earn $150,000/year in retirement from Social Security, Pension Income, and part-time work, then all of your Income will be taxed at 24%. This is not correct.
Instead, think of it more like a waterfall, where if the next dollar you earn happens to bump you up and into a new tax bracket, it is only the amount in the new tax bracket that is taxed at that new and higher rate; rather than all of your money.
Rather than being a flat tax rate, taxes are progressive in nature, meaning we pay proportionately more in taxes as we earn more. Said another way, your marginal tax rate is the amount of tax you pay on your very last dollar of income earned.
See an example below:
Capital Gains
By far the most favorable and generous of the tax treatments in retirement are Long-Term Capital Gains. These types of gains can be produced through selling investments at a profit within your non-retirement account like a Joint Brokerage account or Trust account.
As you can see below in the table, long-term capital gains distribution tax rates will depend on your Ordinary Income levels.
Helpful Pointer #3: A common strategy in retirement, if your income is low enough, and before Required Minimum Distributions begin at Age 72, is to take any money you need to pay your bills from your non-retirement account first. This will result in a lower overall tax rate due to the tax treatment of long-term capital gains.
As you’ll see in the chart below, if your income is low enough, your long-term capital gain distributions can be treated as tax-free!
Image Credit: NerdWalletCapital Gains Part II: Retirement Income from Dividends
A common source of income for many retirees is dividends, which are produced from stocks and mutual funds. Dividends are taxed at capital gains rates, and will always be less than income tax rates.
Interest earned from bond payments on the other hand is taxed at ordinary income tax rates and as mentioned prior, these rates are higher than capital gains rates.
As a result, it is really important to know how much total income your portfolio is producing, what type of product is producing it, and which type of account it’s held in (Taxable, IRA, or Roth).
Asset location plays an important role in your overall retirement strategy because knowing how each dollar earned will be taxed is critical to understanding how to pay less in overall taxes. Whether your investment strategy includes individual stocks, active mutual funds, or index funds, knowing the correct account to place them in is crucial.
Fidelity Investments wrote an incredible article detailing the mechanics of knowing which account to invest in and why depending on the various types of investments you hold.
Note: Long-term capital gains occur when you hold a security position (stock or bond) for longer than one year before selling it.
Real Estate Income from Rental Properties
Income produced from a rental property can be another valuable source of income in retirement; especially when you own the property outright, without a mortgage on it. This results in a consistent monthly cash flow and places less of a burden on pulling money from your retirement accounts.
The income produced from real estate is considered “passive” in nature and is subject to a special set of tax rules. Additionally, rental properties have several tax benefits, with the most common being depreciation, which allows you to offset the gross income generated by the rental.
Working together with your CPA and CFP® to understand how passive income and losses will impact your tax return and fit into your retirement income strategy is crucial to the overall success of your retirement plan.
Final Thoughts
Remember, as we said earlier, when it comes to your money and investing, it’s not what you earn, it's what you get to keep (after taxes).
We all want to make our hard-earned dollars last as long as possible in retirement and not pay more than we have to when it comes to taxes. By knowing your income needs, which we discussed in Part I, you can now begin to more efficiently design how and where you’re going to draw your income from. Doing this will ensure you create the optimal road toward maximizing your retirement dollars.
Stay tuned for Part III on creative retirement income strategies you can use to pay less in taxes.
Disclaimer: Swell Financial is registered as an investment adviser in the state of California and provides advisory services only in states where registered or otherwise exempt from registration. All information presented here is for informational and educational purposes only and should not be relied upon as investment, financial, legal, or tax advice. It is not a recommendation for purchase or sale of any security or investment advisory services. Please consult your own legal, financial, and other professionals to determine what may be appropriate for you. Opinions expressed are as of the date of publication, and such opinions are subject to change.