The do's and don'ts of taxes in retirement
With different rules for different kinds of accounts, taxes in retirement can be complex. Follow these tips to help make the most of your savings
Do you know how your taxes may change in retirement? Will IRA withdrawals be tax-free? How about Social Security benefits? When do you owe at the federal ordinary income tax rate, and what qualifies for the federal long-term capital gains rate? The answers to questions like these could have a big impact on how much tax you owe — and consequently, how long your retirement assets could last.
"Just as it's sensible to pay attention to tax-efficient ways to save for retirement when you're younger, you should start thinking about the tax implications of tapping your retirement accounts as far in advance as possible," says David Koh, managing director and senior investment strategist, Chief Investment Office, Merrill and Bank of America Private Bank.
As you work with your tax professional and financial advisor, if you have one, to develop a tax-efficient
retirement income plan, consider these do's and don'ts for keeping federal income taxes to a minimum. (State and local taxes are not addressed below, so you should consult a tax advisor about those rules).
Do: Know how different types of income are taxed
In retirement, your income may come from annuities, pensions, qualified retirement plans such as 401(k)s and IRAs, taxable savings and Social Security. As you can see in the table below, the tax treatment of all those assets varies widely.
Tip: Holding some of your retirement savings in Roth accounts can help you limit how much income tax you'll owe in a given year.
Retirement tax rates — by income source
|
|
|
| Roth IRA or Roth 401(k), qualified distributions |
Tax-free |
| Traditional IRA, traditional 401(k), pension or annuity income, short-term capital gains, bond income and non-qualified dividends |
Your ordinary income rate* |
| Social Security |
Up to 85% of your benefits are taxed at your ordinary income rate; the rest is tax-free |
| Long-term investment gains, including qualified dividends |
Long-term capital gains rate (plus a potential 3.8% net investment income tax) |
Don't: Limit yourself to one kind of retirement account
Contributing to different types of accounts gives you a greater degree of control over taxes in retirement.
Roth 401(k)s and IRAs, for example, provide federally tax-free income when certain conditions are met and generally don't impose required minimum distributions (RMDs) — which can help you manage how much income tax you'll owe in a given
year.Footnote 1Do: Try to let tax-advantaged accounts keep growing
"For some people, it will make sense to consider tapping taxable accounts first, then tax-deferred and finally tax-free," says Koh. "But, depending on your circumstances, this order may not be right for every person." When you sell long-held investments in your taxable accounts, you'll likely pay long-term capital gains taxes, which are usually lower than the ordinary income taxes you'll owe on distributions from your 401(k)s, traditional IRAs and certain other tax-deferred accounts. "If you're not accessing your retirement funds, they're still growing tax-deferred," Koh adds.
Don't: Make moves without considering what it might do to your tax bracket
Any bumps to your income can cause you to unexpectedly move into a higher tax bracket. This could happen if you sell a business or tap your investments to renovate your home. A higher income can also affect taxes on your Social Security benefits and push up your Medicare premiums.
If you can't avoid moving into a higher tax bracket for a short time, you might want to switch the order in which you tap retirement accounts and draw federal (and potentially state and local) tax-free income from a Roth IRA. You can also pay for qualified medical expenses with your health savings account — those withdrawals are also tax-free. Talk to your tax professional anytime you expect a temporary income bump.
Tip: Watch out for any bump to your income that might temporarily put you in a higher tax bracket.
Do: Look ahead to when you'll turn 73
Even if you're not yet retired, you'll need to consider what happens once you reach age 73 (or age 75 for individuals who reach age 74 after December 31, 2032.) That's generally when RMDs kick in for all employer sponsored-retirement plans, including profit-sharing plans, 401(k) plans, 403(b) plans and 457(b) plans.Footnote 2 The RMD rules also apply to traditional IRAs and IRA-based plans such as SEPs, SARSEPs and SIMPLE IRAs. The RMD rules do not apply to Roth IRAs while the original account owner is alive. If your RMDs are large enough to push you into a higher tax bracket, you may want to consider starting withdrawals earlier to spread out the taxable income.
Tip: Selling investments held in taxable accounts for one year or less could end up costing you more in taxes.
Don't: Overlook how long you've owned an investment
You may end up owing more in taxes than you expect when you sell investments held for one year or less in taxable accounts since those gains don't qualify for the lower, long-term capital gains rate, says Koh. "You'll need to decide whether to hold the asset longer for further potential appreciation, and your tax rate becomes more favorable, or sell it and take your gains now. It's a delicate balance."
Do: Review your tax situation whenever your life changes
A number of life events, says Koh, could trigger a change in your tax circumstances: taking Social Security, deciding to work past retirement age or return to it part time, relocating to a more (or less) tax-friendly state or dealing with increased healthcare costs. Whenever you see a change like this on the horizon, it's time to check in with an advisor and your tax professional.
Another reason for periodic conversations, says Koh, is that tax laws can change. Your best bet is to check in regularly. "There's no one-size-fits-all rule for managing taxes in retirement. The most important thing to remember is that you don't have to make these decisions alone."
Footnote 1 Assuming the withdrawal is a qualified distribution, which generally means it is made after a five-year waiting period and the account owner is 59½ or older. Generally, for a distribution from a Roth IRA to be federal (and possibly state) income tax-free, it must be qualified. A qualified distribution from your Roth IRA may be made after a five-year period has been satisfied (this period begins January 1 of the tax year of the first contribution or the year of conversion to any Roth IRA) and you (i) are age 59½ or older, (ii) are disabled or (iii) use the distribution for the purchase of a first home (lifetime limit of $10,000). In situations where the original account owner is deceased, distributions to the beneficiary are also considered a qualified distribution. If you receive a non-qualified distribution from your Roth IRA, the earnings portion of such distribution generally will be subject to ordinary income tax, plus a 10% early withdrawal additional tax if received before age 59½ unless an exception applies. A 10% early withdrawal additional tax may also be owed on converted Roth IRA principal withdrawn before the end of the five-year period. Although RMDs are not required for the original account owner, RMDs would apply to the inherited IRA account.
Footnote 2 For taxpayers who turn age 72 after December 31, 2022, the required beginning date for RMDs is April 1 of the year after you turn age 73. You are required to take an RMD by December 31 each year after that. If you delay your first RMD until April 1 in the year after you turn 73, you will be required to take two RMDs in that year. You may be subject to additional taxes if RMDs are missed. Please see a tax advisor regarding your specific situation.
Important Disclosures
Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
Investing involves risk including the possible loss of principal. Past performance is no guarantee of future results.
All recommendations must be considered in the context of an individual investor's goals, time horizon, liquidity needs and risk tolerance. Not all recommendations will be in the best interest of all investors.
Opinions are as of 03/13/2024 and are subject to change.
This information should not be construed as investment advice and is subject to change. It is provided for informational purposes only and is not intended to be either a specific offer by Bank of America, Merrill or any affiliate to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service that may be available.
The Chief Investment Office (CIO) provides thought leadership on wealth management, investment strategy and global markets; portfolio management solutions; due diligence; and solutions oversight and data analytics. CIO viewpoints are developed for Bank of America Private Bank, a division of Bank of America, N.A., ("Bank of America") and Merrill Lynch, Pierce, Fenner & Smith Incorporated ("MLPF&S" or "Merrill"), a registered broker-dealer, registered investment adviser and a wholly owned subsidiary of Bank of America Corporation ("BofA Corp.").
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