Retirement Income and Taxation

When you retire, you will need income to finance your normal living expenses. You should consider what the sources of that income will be, and how that income will be taxed. Knowing the general outlines of the taxation of different forms of income may influence your decisions now about investing your retirement savings.

Below are some of the typical types of retirement income and a description of how they are taxed. Although this list does include many common types of income, it is not an exhaustive list. Before making any decisions that involve your taxes or retirement plans, you should get competent tax advice from a tax professional.

In general, there are several categories of income for tax purposes:

Ordinary Income

So-called “ordinary” income is fully taxable in the year received at rates ranging from 10% (for the first few thousand dollars of income) to 39.6% on amounts exceeding around $418,000 or $466,000 depending on your filing status. From a tax standpoint, this is the least desirable type of income to have. This includes income from wages and salaries, commissions, bonuses, and self-employment income; taxable pensions; part of Social Security payments if your other income exceeds a certain amount, and most types of interest income, rents and royalties.

Your Ordinary income tax rate is the default rate for income received, unless some or all of that income qualifies for some sort of deferral or other special tax treatment as described below. Certain deductions and exemptions are subtracted from your total income before the ordinary income tax rates are applied. Those deductions and exemptions are subject to change based on changing tax policy, as are the tax rates themselves and, well, everything else about taxes.

Withdrawals from a traditional IRA, 401(k) or similar plan are currently taxed at ordinary income tax rates in the year withdrawn. Once you reach age 70-1/2, you are required to withdraw annually and pay tax on an amount calculated based on your life expectancy.

Tax Free Income

Some types of income are free of income tax. These include:

• Interest income on municipal bonds (bonds issued by state and local governments)
  Pre-tax returns are about a third lower than taxable bonds of comparable credit quality, so that people in the highest income tax brackets receive after-tax income about equal to taxable bonds.
  If issued by an entity within your state, the interest may be free of state income tax as well.

• Withdrawals from a Roth Individual Retirement Account or a Roth 401(k)
  The contributions to a Roth retirement account are not tax-deductible in the year that you make them. However, the income and/or capital growth on the assets within the Roth vehicle may be withdrawn tax-free if done according to the rules. Tax-wise, this is the most favorable treatment.

• Amounts received as a death benefit on a life insurance policy.

• Amounts received during your lifetime on some insurance products, including certain annuities and life insurance policies. Their special structure provides the tax advantage, usually in exchange for mediocre returns. These are very profitable for the insurance company, though rarely for the customer.

 

Income Taxed at Special Rates

Some kinds of income have their own special tax rates. All of these are the result either of lobbying by some special interest group or an attempt to reward certain behaviors that were seen as socially desirable (again, by some economic, political or social special interest). They include:

Capital Gains

Increases in the value of assets that you own are taxed when you sell the assets. Currently, gains on assets that you hold for less than a year are taxed as “short-term capital gains” at your ordinary income tax rate. Gains on assets that you have held for more than a year are taxed at a special Long Term Capital Gains tax rate. Currently this is either 15% or 20% depending on your other income.

Dividends

So-called “qualified” dividends received on common or preferred stock that meet certain requirements are taxed at 0%, 15% or 20% depending on your other income.   Dividends that do not meet the definition of “qualified” dividends are taxed at ordinary income tax rates.

Certain investment and trading gains

Gains on regulated futures contracts, foreign currency contracts and some options are taxed partially at ordinary income tax rates and partially at long-term capital gains rates, even when held for periods of less than a year.

Tax-deferred Income

Some income types are not taxed when the income is earned. The tax is deferred to the time in the future when you withdraw the money from the tax-deferred vehicle. These include:

• Withdrawals from a traditional IRA or 401(k). The money that you originally contributed reduced your taxable income in the years when you made the contribution, when presumably your tax rate was higher than it is in retirement. When you do withdraw the money, it is fully taxable to you at the ordinary income tax rate that applies at that time.

• Payments from a tax-deferred annuity. With most of these, the gains that built up during the “accumulation phase” between the time that you contributed the money and the time that you withdraw it are not taxed until they are withdrawn. At that time, you may take out a lump sum or “annuitize” it, opting for periodic payments for the rest of your life. In either case, the proceeds are partly taxable at ordinary income rates. The balance is not taxed since it represents return of your original principal. How much is taxed depends on your age when you receive the payments. These investments are a bad deal for almost everybody as deflated as the returns are by layers of fees. They are really bonds or stock investments wrapped up in an insurance structure that provides the special tax treatment, after deducting generous fees for the insurance company (thank the insurance lobbyists).

As we stated above, this list does not include every possible type of income. When making your plans for investing for your retirement, you may have some money in several categories including fully taxable accounts (like a regular brokerage or bank accounts); specially-taxed investments held for dividends, capital gains and/or trading profits; tax-deferred accounts (like a traditional IRA or 401(k); and tax-free accounts (like a Roth IRA or Roth 401(k)). If so, consider the placement of those assets with the highest returns in the least-taxed accounts.

This is a brief summary of the types of tax treatment applied to various kinds of investments and activities. Make sure to get qualified advice on your investment decisions with respect to taxes. If you are in need of expert tax advice, our affiliated company, OTA Tax Pros can provide comprehensive tax services.

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