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A Guide to Understand How Retirement Income is Taxed

When you retire, you’re probably looking forward to lots of time playing with the grandkids, traveling, or pursuing all those hobbies you didn’t have time for when you worked full-time. You’re probably not thinking about taxes, but Uncle Sam definitely is, and just because you no longer work doesn’t mean you can escape paying taxes. Taxes can make quite a big difference in how much money you’ll be able to enjoy. So, let’s take a look at how different sources of income are taxed when you’re retired.

What Taxes Will You Have to Pay on Social Security Benefits?

According to the SSA (Social Security Administration), it depends on your “provisional income” as to how much you will pay in taxes. What’s your provisional income? Take your modified adjusted gross income, add half of your Social Security benefits and all of your non-taxable interest. Then:

  • If you filed as an individual and your combined income is between $25,000 and $34,000, you may have to pay income taxes on up to 50% of your benefits.
  • If you filed as an individual and you earned more than $34,000, up to 85% of your benefits are taxable
  • If you filed a joint return and you and your spouse have a combined income between $32,000 and $44,000 you may have to pay income taxes on up to 50% of your benefits
  • If you filed a joint return and you and your spouse earned more than $44,000, up to 85% of your Social Security benefits are taxable.
  • If you earned less than $25,000 ($32,000 for a couple filing jointly), your benefits are tax-free. 

On the plus side, you can sign up to have taxes taken out of your Social Security benefits before you get them, just like a paycheck.

Ed Slott – a renowned tax expert – on tax benefits of IUL policies

Compare quotes of 30+ IUL products

How are Distributions from Your 401(K) or IRA’s Taxed?

When you socked away money by putting it into your 401(K) or your IRA, you enjoyed the benefits of tax-deferred savings. Now, however, is when it’s time to pay the piper. When you start to take withdrawals from these accounts, it will count towards your provisional income and it will be taxed at your ordinary income tax rate. 

Something to keep in mind is that with 401(K)’s and IRA’s there is a required minimum distribution. At a certain age, you must start to take withdrawals, you can’t leave the money in the account forever. The IRS has a worksheet so you can calculate when you need to start taking withdrawals. 

How are Distributions from your Roth IRA’s Taxed?

The great advantage of a Roth IRA is that you already paid taxes on the money you deposited, so the withdrawals are tax-free. As long as you’ve had the account for more than five years and you’re at least 59 ½ you should be good. 

How are Distributions or Withdrawals from Investment Accounts Taxed?

If you hold onto your investment accounts for more than a year, the earnings will be taxed at long-term capital gains tax rates. 

  • If your income is less than $78,750 your long-term capital gains tax rate is 0%.
  • If your income is more than $78,750 but less than $434,550 for a single person; less than $488,850 if you’re married filing jointly or a qualifying widower; $461,700 for head of household and $244,425 if you’re married filing separately, your long-term capital gains tax rate is 15%. 
  • If you make over the amounts listed above, your capital gains tax rate is 20%. 

There is also a 3.8% surtax you need to be aware of—this is called the Net Investment Income Tax (NIIT) and applies to the investment income over a certain threshold. 

Filing StatusThreshold
Married filing jointly$250,000
Married filing separately$125,000
Single$200,000
Head of household$200,000
Qualifying widower with a dependent child$250,000

If your modified adjusted gross income is over these levels, you’ll pay this surtax on your investments. Surtax means it’s an extra tax—a tax over the capital gains taxes you already paid. 

Short-term capital gains (investments you’ve held for less than a year) are taxed at your ordinary income tax rate. 

How are Withdrawals or Loans from Permanent Life Insurance Policies Taxed?

If you have a permanent life insurance policy, the cash value you earn on the account can be taken out as a tax-free partial withdrawals or loans. Similar to withdrawals from Roth IRA account, withdrawals from a permanent life insurance policy such as Indexed Life Insurance is completely tax free, as long as the policy isn’t lapsed. If you never pay the money back, the death benefit will be reduced. This might be okay, though, if you are prioritizing retirement cash over leaving money to your heirs. 

Also, make sure you don’t allow the policy to lapse, because then, you’ll be hit with a tax bill for the money you withdrew. 

Ed Slott – a renowned tax expert – on tax benefits of IUL policies

Compare quotes of 30+ IUL products

>>MORE: The Best 6 Companies for Indexed Universal Life Insurance

How about Distributions from Annuities?

An annuity is a contract with a life insurance company. You can buy an immediate annuity with a lump sum payout, then the insurance company pays you a certain amount for the rest of your life. This provides you with income through your retirement until you die. If you no longer need the death benefit, you can do a 1035 exchange and the money will be tax-free. Otherwise, the amount over the money you paid in is taxable. For example, if you bought a $100,000 annuity that is now worth $150,000, only the $50,000 is taxable. 

State Income Taxes in Retirement

On top of federal income tax, you have to pay state income tax too. Different states have different income tax rates for retirees. Seven states don’t tax individual income, retirement, or any other income. They are:

  • Alaska
  • Florida
  • Nevada
  • South Dakota
  • Texas
  • Washington
  • Wyoming

In addition, New Hampshire and Tennessee only tax income made on dividends and interest. 

Some states don’t tax Social Security benefits, others do. For more information on how your state taxes income for retirees, see this PDF published by the Tax Foundation. 

Last Thoughts

Taxes can take a big chunk out of your retirement income. Tax law is also complex and changes quite often. Managing the taxes on your retirement income will have a huge effect on how much you’re able to enjoy your retirement.

Ed Slott – a renowned tax expert – on tax benefits of IUL policies

Compare quotes of 30+ IUL products

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