Taxes in Retirement

This guide explains the basics of our tax system and the different kinds of taxes you might pay in retirement.

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By Michael Sharpnack

Most people will pay less taxes in retirement than they paid while they were working.

But if you don’t navigate the tax laws carefully, you can end up with a bigger tax burden than expected in retirement.

Retirement creates new opportunities for tax planning because you usually have more income sources to choose from.

While working, most people have one income source. But in retirement, new sources enter the picture: IRAs, Roth IRAs, taxable accounts, pensions, and Social Security, for example.

The more income sources you have, the more flexibility you have to choose when and where to take income from.

More choices mean more opportunities to reduce taxes—but also more opportunities to make mistakes.

This guide is an overview of what taxes in retirement will look like, and it lays the foundation for tax-planning strategies.

Here’s what we’ll cover:

• Federal income taxes
• FICA taxes
• Capital gains taxes
• Inheritance taxes
• Taxes on retirement accounts
• RMDs
• Taxation of pensions
• Taxation of annuities

Federal Income Taxes

The US federal income tax system is based on progressive taxes—higher tax rates on higher income-earners.

The tax rates are broken up into tax brackets that apply to income levels. No matter how much you make, some income is always taxed at the lower brackets.

Even if your taxable income is $1 million dollars, not all of it is taxed at the highest bracket; some of it will be taxed in lower brackets, and a portion of it will be tax free.

This is an important concept in retirement because you can sometimes move income around to take advantage of lower tax brackets with strategies such as Roth conversions.

Tax brackets apply to taxable income, which is income after deductions and exemptions. For most people, that means the standard deduction.

If you’re married, filing jointly, and under age 65, then the standard deduction is $25,100. (You get an extra $1,300 once you hit 65.) Subtract that from your income to get taxable income. If your income from work is $50,000, then your taxable income is 24,900.

If you’re using the standard deduction:

Taxable Income = Adjusted Gross Income (AGI) – Standard Deduction

Standard deduction for 2021:

Itemized deductions replace the standard deduction and are beyond the scope of this guide.

Here are the tax brackets in 2021:

It’s helpful to think of the tax brackets stacked on top of each other, including the standard deduction. Here’s what it looks like using the Unmarried category (ending at the 24% bracket):

Total income is on the left, and the amount taxed at each bracket is on the right.

No matter how much your income total, the first $12,550 of income is always taxed at $0 because of the standard deduction. The next $9,950 of taxable income is always taxed at 10%. The next roughly $30,000 of income is always at 12%, and so on.

Let’s go through an example. John is unmarried and will make $62,000 in 2021. How much tax will he owe (not counting any other deductions or credits)?

First, take out the standard deduction of $12,550. So, $62,000 – $12,550 = $49,450. The first 9,950 is taxed at 10%, which equals $995 in taxes. The next $30,574 is taxed at 12%, which equals $3,057.4. And the rest of his income, which is $8,925, is taxed at 22%, which equals $1,963.5. Add it all together to get our total tax owed. $995 + $3,057.4 + $1,963.5 = $6,015.9.

Here’s a visual of John’s tax liability:

Just because he’s in a 22% tax bracket doesn’t mean that he pays 22% in taxes.

This is where marginal tax rate and average tax rate come in.

Marginal Tax Rate

Marginal tax rate is the tax you pay on the next dollar of income.

If you’re unmarried and you have $70,000 of income, the marginal rate is 22%. If you make one extra dollar, that dollar is taxed at 22%.

If you’re unmarried and you have $87,000 of income, you’ve bumped up a marginal tax bracket. Now, one extra dollar is taxed at 24%.

Average Tax Rate

Average tax rate is the total tax you pay as a percent of income.

To find your average tax rate, divide your tax owed by your total income. If you make $100,000 and you pay $10,000 in taxes, then your average tax rate is 10% (10,000/100,000).

In that case, even though your average tax rate is 10%, your marginal rate for an unmarried person is 24%.

Using John’s example above—unmarried with $62,000 income in 2021—he is in a 22% marginal tax rate, but he has a 9.7% average tax rate (6,015.9/62,000).

FICA Taxes (Social Security and Medicare)

Not only do we pay federal income taxes, but we also pay FICA (Federal Insurance Contributions Act) taxes on earned income.

FICA taxes are taxes for Social Security and Medicare, and if you earn a regular paycheck and receive a W2, they are automatically withheld from each paycheck.

The Social Security tax is currently 6.2% and goes toward people currently receiving benefits. You only pay 6.2% on the first $142,800 of income in 2021. Anything over that income limit you currently don’t pay Social Security taxes on.

The medicare tax is currently 1.45% and pays for those currently on medicare. There’s also an additional .9% increase in the tax on wages in excess of $200,000. And, unlike the Social Security tax, the medicare tax has no income limit.

Total FICA tax: 7.65% on earned income in 2021.

You only pay FICA taxes on earned income, which is income from work. This is important because it doesn’t include passive income like pensions and retirement account distributions.

Employers also pay FICA taxes on your behalf. They pay the same amount as you, so 7.65% from you and from your employer equals 15.3% taxes paid on your behalf. If you’re self-employed, though, you are responsible for the full 15.3%.

Most income in retirement is not subject to FICA taxes, which lightens the tax burden some.

FICA taxes are not held for you in your own account like a 401(k). Instead, the FICA taxes that you pay when you are working cover the benefits of those who are not working. Once you stop working, the new generation of workers pays for your benefits.

Capital Gains Taxes

Capital gains taxes apply to the growth of an asset when the asset is sold.

If you had put $1,000 into Google when it first went public, your account would be worth about $32,000 by the end of 2020. But as long as you never sold any of the stock, you would owe $0 in taxes on the gain. But once you sell the stock, $31,000 would be subject to capital gains taxes.

The capital gains subject to taxes equals the sell price of the asset minus the basis.

Basis is how much you have invested in the asset. In the Google example, the basis is $1,000. If you buy a house for $250,000, your basis in the house is $250,000. If you then sell the house for $500,000, your capital gain from the sale is $250,000 (assuming there’s no depreciation).

For taxable investment accounts, the basis can increase each year even if you don’t put any more money into it. This is because the basis increases for any taxes paid on interest and dividends from the accounts.

For real estate investments, the basis decreases if you use the deduction for depreciation.

Capital gains are subject to their own tax rates, separate from the income tax rates.

Also keep in mind that you don’t pay capital gains taxes on assets inside certain types of accounts, like IRAs and Roth IRAs. More on that below.

First, you must determine if the capital gains are long term or short term.

Short Term vs. Long-term Capital Gains

Short term capital gains apply when you sell an asset that you’ve held for less than a year. The rate of short-term capital gains is the same as your ordinary income rate.

Long-term capital gains are for assets held more than a year, and they have their own tax rates.

2021 Long-term Capital Gains Rates:

These rates apply to only the capital gains you have from selling an asset—called realized gains.

Unrealized gains are from growth that you haven’t sold yet, and therefore you haven’t paid taxes on yet.

Keep in mind that the thresholds above include both ordinary income and capital gains. For example, if you had $30,000 of ordinary income and $10,000 of capital gains, then your capital gains rate would be 0%. But if you had $41,000 of income and $10,000 of capital gains, you would pay 15% on the $10,000 of capital gains, for a capital gains tax of $1,500.

While ordinary income counts for capital gains brackets, capital gains don’t count toward your ordinary income brackets.

An unmarried individual with $40,000 of taxable income and $10,000 of capital gains would be in the 12% bracket for federal income—the capital gains wouldn’t bump you up into the 22%—but they would be in the 15% capital gains bracket.

Inheritance Taxes

Money that you leave behind when you die is subject to the federal estate tax rules. These rules are complicated, but here are some of the most important points:

Estate taxes apply to the total value of all assets you leave behind when you die.

There are both federal and state estate taxes. Tennessee has no estate tax right now, but if you live in another state, check their specific rules because each state is different.

The federal estate tax rate is 40% on taxable amounts over 1 million, but it doesn’t apply in most situations because the estate tax exemption is so high.

For 2021, the estate tax exemption is $11.7 million per individual and $23.4 million per couple.

That means that your estate doesn’t pay taxes on the first $11.7 million dollars in assets per individual.

The exemption is, however, set to expire and revert back to about $5 million in 2026—if Congress doesn’t do anything about it—but even then it won’t apply to most people, as couples will still have an exemption over $10 million.

If your estate looks to be more than the above exemptions, make sure to talk to a qualified estate planning attorney.

Even if your estate won’t be above the exemptions, you still might want to talk to an estate planning attorney, because good estate planning has other benefits as well.

Step Up in Basis

When an asset passes to an heir after death, it receives a step up in basis (under current law).

A step up in basis is when the basis of the asset gets an increase in basis to the value of the asset on the date of death, instead of the original basis.

For example, say your dad bought a property in 1970 for $10,000, and today it’s worth $200,000. If he sold it today, he would have $190,000 of gains (basis of $10,000 minus $200,000 sale price). But if he doesn’t sell it and you inherit it after he dies, your basis in the property gets a “step up” to $200,000.

With a step up in basis, if you immediately sell the inherited asset, you owe no taxes on the sale.

This is a powerful financial planning tool that can save taxes and increase the value of your estate when used properly.

Taxation of Retirement Account Withdrawals

When taking income from an investment portfolio, it’s important to understand how that income will be taxed.

Investment accounts have three categories of tax treatment:

1. Pre-tax
2. Post-tax
3. Taxable (also called non-qualified)

Understanding the differences here lays the foundation for distribution strategies—the order you choose to draw from these accounts.

Different account types do not necessarily mean different investments. For example, you can have a traditional IRA and a Roth 401(k) with the same investments in them. But the tax treatment and restrictions on those accounts are different.

Pre-tax Retirement Accounts

Pre-tax is the most common type of account, and many people have most or all their retirement money here.

When you contribute to pre-tax accounts, you receive a tax deduction. Then, the earnings grow tax-free until you take the money out. This offers a great tax benefit for investing while you are working.

But in retirement, any withdrawals you make from pre-tax accounts are taxed as ordinary income. So these are actually the least advantageous accounts to own in retirement.

That doesn’t mean you shouldn’t contribute to them when working, though, because your taxes are usually higher while working—so the tax break while working often is greater than the disadvantage of paying taxes in retirement.

Whether or not to contribute to a pre-tax or a post-tax plan depends on your specific tax situation.

Pre-tax accounts also have many restrictions, and each type of account has its own nuances. For example, most pre-tax accounts, like IRAs, put a penalty on withdrawals before age 59 1/2.

Pre-tax account summary:

• Deduction for contributions
• Tax-free growth
• Fully taxable withdrawals

Types of pre-tax accounts:

• 401(k)
• 403(b)
• IRA
• 457
• Pensions
• Profit-sharing plans

Post-tax Accounts

With post-tax accounts, you receive no tax deduction on the money you put in, but they still grow tax-free until you take the money out.

Then, withdrawals in retirement are tax-free, making these accounts the best to own when you reach retirement. But that doesn’t mean you should always contribute to them while working. Many times the tax deduction from pre-tax accounts outweighs the benefit of tax-free withdrawals in retirement.

Post-tax account summary:

• No deduction for contributions
• Tax-free growth
• Tax-free withdrawals

Types of post-tax accounts:

• Roth IRA
• Roth 401(k)
• Anything with “Roth” in it

Other types of post-tax accounts:

• Non-deductible IRAs (Post-tax contributions, tax-deferred growth, but earnings are taxed on withdrawal. These have other complications as well.)
• Non-qualified annuities (Post-tax contributions, tax-deferred growth, earnings are taxed last-in first-out. More on these below.)

Taxable Accounts

This is the broadest category of investment account. Taxable accounts go by several names: non-retirement accounts, non-qualified accounts, or personal accounts.

Taxable accounts do not qualify for tax-deferred growth on earnings. Instead, they are taxed a little each year. This “tax-as-you-go” feature limits their growth potential.

Taxation of taxable accounts can get complicated, but for standard accounts with stocks, bonds, and mutual funds, it’s straightforward.

Taxes on taxable accounts have three parts: interest, dividends, and capital gains.

Interest from bonds in the account are taxed as ordinary income in the year the interest was paid. This is true even if the interest is reinvested back into the account.

Dividends are taxed at capital gains rates in the year the dividend was paid—again, you still pay tax on the dividends even if you don’t withdraw them.

Capital gains are triggered any time an appreciated asset is sold within the account. Even if one stock is sold to buy another stock and no money is actually withdrawn, you must pay capital gains taxes on the sale.

Withdrawals from taxable accounts are also subject to capital gains tax rules. The money you put into the account can be taken out tax free, while growth in the account is taxed at capital gains rates.

This is usually handled with the average cost basis method. If you put $100 into the account and it’s now worth $200, then any withdrawals will be considered half basis and half gains.

Taxable accounts are the most flexible, as they do not have limits on contributions or withdrawals. Unlike pre-tax and post-tax accounts, you can access the money at any time. They trade that flexibility, however, for a lack of tax breaks.

Taxable account summary:

• No deduction for contributions
• No tax-free growth on income
• Withdrawals taxed at capital gains rates

RMDs (Required Minimum Distributions)

An RMD (Required Minimum Distribution) is an amount of money the government requires you to withdraw from certain types of accounts after a certain age. Which accounts and which ages will be explained below.

RMDs are an important part of tax planning because if you’re not careful, they can cause you to pay high taxes in later years, cutting into your estate.

The government created these rules to keep you from deferring taxes forever. They force you to take the money out each year so that you pay taxes rather than letting it continue to grow tax free.

You can choose to do whatever you want with the money once you withdraw it except put it back into the account.

The RMD rules apply to qualified retirement plans, except for Roth IRAs.

Common accounts subject to RMDs:

• Traditional IRAs
• Simple IRAs
• SEPs
• 401(k)
• 403(b)
• 457(b)
• Profit sharing plans
• Certain defined contribution plans

While Roth IRAs are not subject to the RMD rules, Roth 401(k)s, Roth 403(b)s, and Roth 457 retirement plans are.

If you don’t take your full RMD, then you pay a 50% penalty tax on the amount not withdrawn. For example, if your RMD was $1,000 but you only withdrew $500, then you would pay a 50% penalty on the remaining $500, so $250 would go to the IRS.

With the passage of the SECURE Act in 2019, there are two scenarios for when RMDs start.

• If you were age 70 1/2 before January 1 of 2020, then you’re already subject to RMDs
• Otherwise, RMDs start at age 72

However, employer-sponsored retirement plans—like 401(k)s and (403(b)s—have one exception: If you still work for the employer when you reach the age for RMDs, then you may qualify for the still-working exception, which allows you to delay RMDs until you stop working. But you should consult with your employer or tax professional to see if you qualify.

Pensions

Most pensions are fully taxable as ordinary income. However, pensions can be partially taxable if you have an investment in the contract, meaning you’ve contributed to your pension from your own pocket in some way.

Also, if your employer withholds income from your paycheck that goes toward your pension, that may be considered a contribution to the pension.

If you have no investment in the pension—it’s been contributed to entirely by your employer—then your pension will be fully taxable.

If you’re unsure how your specific pension is taxed, you should look at your plan document or consult the person responsible for your pension.

States tax pension income differently. Some include it as income and some do not, so you will want to check your state to see how it will be taxed.

Social Security Taxes

Social Security may or may not be taxed depending on your total income picture.

There is a calculation to determine how much of your Social Security income is included in your income. Depending on the calculation, it can range from 0% to 85% of Social Security benefits included in your income.

The calculation starts with provisional income, which is AGI plus half of your Social Security benefits, and then adds in any tax-exempt interest such as municipal bonds.

Once you calculate provisional income, there are three thresholds that determine how much of your benefits are included in your income.

Tax planning strategies often revolve around Social Security taxation.

Triggering extra income in certain years can create a “tax torpedo” where not only does it increase your tax bracket, but it also increases the amount of Social Security subject to tax, medicare premiums, and capital gains taxes all at once.

Medicare Surcharges

Related to the Social Security thresholds are the thresholds for Medicare surcharges, called IRMAAs (Income-Related Monthly Adjustment Amount), which is a fancy way of saying Medicare premiums.

As your income increases, so do your medicare premiums (IRMAAs).

Once you start receiving Social Security benefits, these premiums are automatically withheld from your Social Security check. Many people are confused when they see their Social Security check reduced by an IRMAA, and they can be surprised when the IRMAA jumps up because they crossed a threshold.

To calculate the thresholds, they use your income from two years ago. So your 2021 premium is based on the income you made in 2019.

Here are the thresholds in 2021 (based on income from 2019):

These thresholds are for Medicare part B, which is mandatory for most people to have. Parts C and D are not required and have their own rates.

Annuities

There are two types of annuities for tax purposes: qualified and non-qualified.

Non-qualified annuities—the most common type—are taxed last in, first out, or “LIFO.” That means whatever money came into the account last is considered to be the first money withdrawn when you start taking the money out.

For example, if you put $100,000 into an annuity and then it grows to $150,000, the $50,000 of gain is considered the last in. So when you withdraw from the account, the first $50,000 will all be taxable, and the rest will be considered a tax-free return of basis.

If you annuitize—or turn the account into lifetime payments—you may be able to spread the gain over several years.

Qualified annuities are annuities paid with pre-tax accounts, like IRAs or 401(k)s. Withdrawals and payments from qualified annuities are fully taxable, same as ordinary IRA withdrawals.

Summary

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*Advisory services offered through Paul Winkler, Inc. (‘PWI’), an investment advisor registered with the State of Tennessee. PWI does not provide tax or legal advice: please consult your tax or legal advisor regarding your particular situation. This information is provided for informational purposes only and should not be construed to be a solicitation for the purchase of sale of any securities. Information we provide on our website, and in our publications and social media, does not constitute a solicitation or offer to sell securities or investment advisory services, or a solicitation to buy or an offer to sell a security to any person in any jurisdiction where such offer, solicitation, purchase, or sale would be unlawful under the securities laws of such jurisdiction.