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Taxes in retirement: What you need to know

When you start drawing down assets in retirement, the tax implications can be confusing. Here are some tips to consider to create a tax-efficient strategy that can help you enjoy these years to the fullest.

 

QUESTIONS ABOUT TAXES don’t end in retirement. Your tax bracket may shift, up or down. And the order in which you tap your retirement accounts and other savings could have a big impact on how much tax you owe — and consequently, how long your retirement assets could last.

 

 David Koh headshot“You should start thinking about the tax effects of tapping your retirement accounts as you approach retirement.”

— David Koh, senior investment strategist, Chief Investment Office, Merrill and Bank of America Private Bank

Do you know whether your withdrawals will be tax-free? If not, will they be taxed at your federal ordinary income tax rate or at the federal long-term capital gains rate? “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 effects of drawing from your retirement accounts as you approach retirement,” says David Koh, managing director and senior investment strategist, Chief Investment Office, Merrill and Bank of America Private Bank.

 

Consider the tips below as you work with your financial advisor and tax professional as you develop an approach to help minimize your effective tax rate and the amount of your tax liability.

 

Know how different types of income are taxed

As you approach or reach retirement, identify all the sources of income you may have in retirement, which might include annuities, pensions, qualified retirement plans such as 401(k)s and IRAs, and Social Security. “Understanding how various accounts are taxed in retirement is crucial as you’re figuring out a sensible order for withdrawing from them,” says John P. Schultz, partner at Genske, Mulder & Company and chair of the California Society of Certified Public Accountants tax committee.* But making those plans without the help of a professional can be challenging.

Chart titled, “Retirement tax rates – by income source.” To the left is a pie graph of blues and reds and to the right is a document with “TAXES” written on it, and an empty chart; a magnifying glass highlights a percentage sign, “%.” Below these images are two columns: The column on the left refers to “Type of Income” and the column on the right refers to “Typical Federal Tax Rate.” The rows correspond as follows: “Roth IRA or Roth 401(k), qualified annuity contributions” with “Tax free;” “Traditional IRA, traditional 401(k), pension or annuity income, short-term capital gains, bond income and non-qualified dividends” with “Your ordinary income rate;” “Social Security” with “Up to 85% of your benefit is taxed at your ordinary income rate; the rest is tax-free;” “Long-term investment gains, including qualified dividends” with “Long-term capital gains rate.”

Sources: IRS.gov Publication 590-B (2020), Distributions from Individual Retirement Arrangements (IRAs); Publication 575 (2020), Pension and Annuity Income; Topic No. 404 Dividends, January 2022. SSA.gov “Income Taxes And Your Social Security Benefit,” January 2022.

Contributions to a designated Roth 401(k) account or Roth IRA are federally tax-free when you withdraw those funds, as are the earnings, 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.1 Upon distribution, principal contributions to non-qualified annuities are generally tax-free, though any earnings on those accounts are generally included in your taxable income upon distribution.

 

Debra Greenberg headshot“For some people, it will make sense to consider tapping taxable accounts first, then tax-deferred and finally tax-free.”

— Debra Greenberg, director, Retirement & Personal Wealth Solutions at Bank of America

On the other hand, withdrawals from traditional 401(k) plan accounts and certain other employer-sponsored plans, as well as traditional IRAs — basically, any retirement plans funded with pretax or tax-deductible money — will generally be subject to federal and any ordinary state income taxes upon withdrawal.

 

In your nonretirement accounts, bond income and some of the dividends you receive from stocks and mutual funds may be taxed at your federal ordinary income rate, but qualified dividends and long-term investment gains are generally taxed at lower long-term capital gains rates. State and local tax treatment may vary. Finally, don’t forget Social Security. Depending on how much income you collect from other sources, up to 85% of your benefits may be considered taxable income. Your tax professional can work with your financial advisor to help you put in place a plan for your future retirement income.

 

Develop a thoughtful withdrawal strategy

“For some people, it will make sense to consider tapping taxable accounts first, then tax-deferred and finally tax-free,” says Debra Greenberg, director, Retirement & Personal Wealth Solutions at Bank of America. “But, depending on your circumstances, this order may not be right for every person.” If most of your investment gains are from long-term assets held outside of IRAs, you’ll likely pay long-term capital gains taxes, which are generally lower than what you pay on distributions taxed as ordinary income from your 401(k)s, traditional IRAs and certain other tax-deferred investments. “Also, remember that if you're not accessing your retirement funds, they’re still growing tax-deferred,” Greenberg says.

 

That said, if you’re an active investor, 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 as it appreciates, and your tax rate becomes more favorable, or sell it and take your gains now. It’s a delicate balance,” he notes. Keep in mind, too, that under current law, you could boost your tax-free assets by converting traditional IRAs to Roth IRAs, which offer tax-free qualified distributions when certain conditions are met and generally don’t have required minimum distribution (RMD) requirements during the account owner’s lifetime.

 

Even if you’re not yet retired, you’ll need to consider the impact of your retirement savings on your taxes once you reach age 72 (or age 70½ if you turned 70 ½ before January 1, 2020). That’s when you must begin taking RMDs from some of your retirement accounts, which is likely to boost your taxable income.

 

Avoid moves that could put you in a higher tax bracket

RMDs and other changes that bump up your income can result in what’s called “bracket creep” — which is, basically, unexpectedly slipping into a higher tax bracket. You might, for instance, receive an inheritance or sell a piece of real estate. You might also slip into a higher tax bracket by taking a large distribution from a taxable account to, say, renovate your home or buy a new car, Schultz notes. “When you’re in retirement, even a small change in your income can have an impact on what you pay in taxes, cutting into the amount you were expecting as cash flow,” says Schultz. He also points out that a higher income can have an effect on the taxability of your Social Security benefits and push up your Medicare premiums.

 

“When you’re in retirement, even a small change in your income can have an impact on what you pay in taxes.”

— John P. Schultz, CPA and partner at Genske, Mulder & Company

This is one reason it can be useful to fund different kinds of retirement accounts during your working years. Weighing your choices now can give you a greater degree of control in retirement — you can manage the amount of taxable income you receive and make adjustments when necessary. For instance, when you start taking RMDs, it might make sense to take any additional withdrawals from tax-free accounts instead of taxable ones, suggests Greenberg. You can also pay for qualified medical expenses with your health savings account, and since those qualified withdrawals are tax-free, they won’t affect your taxable income. Talk to your advisor and tax professional any time you expect a temporary income bump.

 

Review your tax situation whenever your life changes

A number of life events, says Greenberg, could trigger a change in your tax circumstances: taking Social Security, deciding to stay at work or return to it part time, relocating to a more (or less) tax-friendly state, dealing with increased health care costs or other expenses. Whenever you see a change like this on the horizon, it’s time to check in with your advisor and your tax professional.

 

Another reason for periodic conversations, says Koh, is that tax laws can change. Increases in capital gains rates and higher rates for wealthier taxpayers have both been discussed on Capitol Hill in recent months. For all these reasons, your best bet is to regularly check in with your advisor and tax pro, says Greenberg. “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.”

Earnings from a Roth designated 401(k) account and Roth IRA are federal income tax-free if the requirements for a “qualified distribution” are met. A qualified distribution generally occurs if the participant meets the five-year rule and is at least 59½, disabled or deceased. The five-year period for a Roth 401(k) begins on the first day of the tax year of your first designated Roth contribution to your account under the plan, whereas, for a Roth IRA, it begins on the first day of the tax year of your first contribution to any Roth IRA. If you receive a nonqualified distribution from your Roth designated 401(k) account or Roth IRA, any earnings distributed generally will be subject to federal ordinary income tax, plus a 10% additional federal tax.

 

IMPORTANT DISCLOSURES

 

*As a CPA and partner at Genske, Mulder & Company, Mr. Schultz is not affiliated with Merrill. Opinions provided are his, do not necessarily reflect those of Merrill and may be subject to change.

 

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 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 01/28/2022 and are subject to change.

 

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.”). 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.

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