One of the major questions that any person has when they are contemplating their retirement is where is their income going to come from. Not only where is it going to come from, but what are the tax implications of the income you will be taking? Income planning is much more than simply looking at how much money you have saved in the bank. You may have reached that savings goal that you had, maybe you reached the $1 million dollars that you wanted, but do you know what the money will translate to after taxes? Do you know what savings will be taxed when taken as income and which savings will be tax free? There are a few different types of streams, or buckets, of income that you should plan for when calculating cash flow for your retirement.
The first piece of the retirement income puzzle for many people is Social Security. As most of you know, Social Security is a government program that you pay into, via taxes from your paycheck, for your entire working life. The result of all your payments is a system in which you can choose to receive income payments from retirement age onward. You can elect to start taking Social Security as soon as age 62, but by doing so you will not receive your full retirement benefit. At age 67 is when you reach full benefits as the Social Security Administration deems that to be full retirement age. If however you wait until age 70, past your full benefit age, your monthly Social Security payments will be higher. For more information on the calculation of SS benefits as well as your estimated benefit amount, create your free account on the Social Security Administrations website here at https://www.ssa.gov/. As for the taxability of your monthly Social Security payments, you will have to pay taxes on up to 85% of your Social Security benefits if you are an individual filer who makes $25,000 or more, or a joint filer who has income of $32,000 or more. So, in example if Social Security was your only reportable income and you receive monthly payments of $2,400, you would be taxed at your marginal tax rate on $24,480 of that income, (85% of the payments). In summation, despite the fact you pay in to social security for the entirety of your working life, you will still most likely have to pay taxes when you elect to turn it on in retirement.
Pre-tax Retirement accounts and Qualified Annuities
Many people utilize Traditional IRAs as well as 401(k)s to save for retirement. It is prudent to use retirement investment vehicles to ensure that you will not solely be relying on Social Security. It may even be preferred to not have to rely on Social Security at all. Both of these vehicles are great because they provide for tax-deferred growth. 401(k)s are an added employment benefit because your contributions to such an account may be matched by your employer up to a certain percentage. Because the growth is tax-deferred, your withdrawals in retirement are taxed the same way earned income is taxed. This means that the income you take from those accounts is taxed at your marginal income tax rate. Often for people this means that they will be in a lower tax bracket in retirement as they have lower total expenses meaning they don’t need to take as much income as they would during their working years. There are however no yearly limits on how much you can withdraw from a Traditional IRA like there are limits to how much you can contribute. The taxability of traditional IRA and 401(k) withdrawals is the same as the taxability of distributions from a Qualified Annuity. A qualified Annuity is an annuity that is funded with pre-tax dollars. Annuities offer an investor the ability to have set payments sent to them in retirement. Annuities are often held within a person’s IRA, so when a person purchases an annuity within their traditional IRA it is deemed a Qualified Annuity funded with pre-tax dollars. Oftentimes annuities are funded with pre-tax dollars or are held within a person’s IRA. For that reason, these types of annuities are deemed “qualified annuities”. This also means that distributions are fully taxable as income.
Roth IRAs and Non-qualified Annuities
The growingly popular Roth IRA allows after-tax dollars to be invested. This means that since the money you invest is already deemed to have been taxed, you receive tax-free growth and also tax-free withdrawal. While there is a limit of $6,000 per year that you can contribute, there are no yearly limits on how much you can withdraw. In addition to qualified annuities there is also what are referred to as non-qualified annuities. Any contributions you make to such an annuity are able to be distributed tax-free after age 59 ½. However, while contributions are distributed tax free, any earnings withdrawn are taxed like a Qualified annuity. Any amount withdrawn over your basis is taxed at your marginal tax rate. An example would be if you invested $50,000 dollars into a Variable Annuity. That VA then grows to $55,000. If you took distributions of $52,000, you would receive $50,000 tax free but would have to pay income taxes on the $2,000 over your basis.
A taxable account, also called brokerage accounts, are investments accounts that don’t offer the same tax-deferred growth advantages that IRAs do. It is very likely that you have some experience with these types of accounts because investors often use them as an avenue to do some trading or hobby investing. Some also use such an account for long-term investing as well. Brokerage account investments are eligible for taxes while in the account. If you sell a position at a gain you have to pay capital gains tax, (Short-term or long-term depending holding period. Long-term capital gains tax is preferential). If one of your investments pays interest or pays a dividend you will be taxed accordingly. The beauty of taxable accounts is their flexibility. Since you are actively being taxed each year on your investments, you can choose to cash out that money whenever you prefer. You do not pay additional income tax on funds you already paid capital gains tax on.
As you can see, there are a variety of places you can have income flow through in retirement. That is why it is important to differentiate your savings into buckets when income planning. You have to know how much money will be lost to taxes when you’re withdrawing from your 401(k). It is important to plan for taxes that will be due when you withdrawal from your traditional IRA. Use your Roth IRA as the powerful tool that t is meant to be. All of these work together to create the income you need for the retirement lifestyle you want.
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All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.