How Are Different Retirement Income Sources Taxed? And, How Does Tax Withholding Work in Retirement?

Retirement tax planning is a critical part of preparing for a secure future. The good news is that with so many possible retirement income sources, you have many different opportunities to potentially reduce your tax burden. And, you may even discover that reducing taxes can enable you to retire a little earlier than you might have imagined. It is also important to get your tax withholdings right. Before you retire, most of your income probably comes from one place: your paycheck. And as you probably noticed, the government takes a bite out of each one. After retirement, you are more likely to get income from savings, passive income sources, Social Security and more. And, you need to be more responsible to make sure that withholdings are being made so that you aren’t unpleasantly surprised when it comes time to pay Uncle Sam. To make matters more complicated, some of those sources have very specific taxation rules and the taxes are often different for federal vs. state collections. Financial services giant Morgan Stanley lists taxes as one of the five biggest challenges in retirement. Taxes can be a huge opportunity for keeping more of your money.

Social Security

You pay Social Security taxes on every paycheck you get from your job, but did you know that you may also pay taxes on your Social Security benefits? Depending on your level of income, you can pay as much as 37% tax on 85% of your benefit! (Some states don’t tax Social Security. Read Which Are the Most Tax-Friendly States for Retirees 2020? to find out which ones do and which ones don’t.) In our article Taxes on Social Security: Don’t Get Taken for a Wild Ride we give you a complete breakdown of how your Social Security benefits are taxed. If your taxes are especially complicated, you can model them in the Boldin Retirement Planner, and you may want to seek a tax professional’s advice for minimizing your tax burden. Lowering your taxable income is good for your Social Security benefit, and one way to do that is to move any income-producing assets that are not tax-protected into an IRA.

Social Security Tax Withholding

Social Security doesn’t automatically withhold taxes either, so, in the worst-case scenario where you don’t elect to have taxes withheld, you could owe the government almost $15,000 in tax at the end of the year. Fortunately, you can submit a Form W-4V to the IRS to have income taxes automatically withheld from your Social Security benefit.

Pensions

Most pension payments are treated as taxable income by the IRS. Whether the money is distributed as a lump sum or in installments, the money is part of your Adjusted Gross Income (AGI), which you use to find out home much of your income is taxable. If your pension income boosts your gross income above the standard deduction ($12,400 for single filers, $24,800 for joint filers, and an extra deduction of $1,650 for singles over 65 or blind and $1,300 for married couples over 65 or blind for 2020), you will have to pay federal income tax on it.

Pension Tax Withholdings

The IRS automatically withholds 20% of your pension income if you don’t request a different withholding amount. Some states don’t tax pension payments, and this is particularly true if the pension is from the state or government or a municipality within the state. In the states that do tax pension income, your pension provider may automatically withhold state taxes. Many pensions will withhold taxes for you the same way your employer withheld taxes for you when you were working. But be sure to double-check. You can request that a pension does not withhold taxes if you would prefer to make a quarterly payment. Also, make sure your pension’s tax withholding amount works with the rest of your income. If you set your withholding too high, you may get money back as a tax return, but you’re also letting the government hold your money interest free for a year. To request withholding for your pension income, you must fill out IRS Form W-4P. NOTE: In the Boldin Retirement Planner you can specify the tax treatment of your pensions.

Annuities

Taxes on annuities depend on whether the annuity is qualified or non-qualified. A qualified annuity is purchased with pre-tax dollars, and a non-qualified annuity is purchased with after-tax dollars. Qualified annuity definition: An annuity funded with pre-tax, or untaxed money. Non-qualified annuity definition: An annuity funded by after-tax or taxed money. The money in an annuity grows tax-free until you start taking payments, and this means annuities are tax-deferred. But once you start taking payments you must pay taxes, either on both the principle of the annuity and the interest, if it’s a qualified annuity, or on the interest only if it’s a non-qualified annuity. If you withdraw money from your annuity before you turn 59 ½, you may have to pay a 10% penalty. On the other hand, twelve states don’t tax annuity payments (or pension payments):

• Alabama
• Alaska
• Florida
• Illinois
• Mississippi
• Nevada
• New Hampshire
• Pennsylvania
• South Dakota
• Texas
• Washington
• Wyoming

Annuity Withholdings

Annuities are treated the same as pensions by the tax code when it comes to withholding. You can request a Form W-4P to set a different withholding amount, but the federal tax default rate is 20%.

Traditional, SEP and SIMPLE IRAs

There are several ways you can reduce your taxes on the money in traditional, SEP and SIMPLE IRAs. The important thing is to make sure your RMDs don’t inadvertently push you into a higher tax bracket or increase your taxes on Social Security benefits or Medicare. Read our article How to Manage Retirement Withdrawals to Pay Less in Taxes and Maximize Income for more insight on how to manage withdrawals from IRAs. The Boldin Retirement Planner will help you visualize how distributions are taxed and how that fits into your overall tax strategy.

IRA Withholdings

Required minimum distributions (RMDs) and other withdrawals from traditional, SEP, and SIMPLE IRAs are taxed as regular income. As a rule of thumb, the custodian for these IRAs will withhold 10% automatically for taxes, though you could owe more depending on your AGI. You don’t have to worry about tax withholding on a Roth IRA because you already paid tax on that money. 🙂

401(k)s

As with most defined contribution accounts, like traditional IRAs, qualified 401(k) accounts receive pre-tax contributions, and distributions (RMDs) are taxed as regular income. To reduce your taxable income across your different sources of income, you can delay taking distributions from your 401(k), or you can employ these strategies: Rollover your distributions into a traditional IRA. Though you will have to take distributions from a traditional IRA at some point, you can get a tax advantage in a particular year by rolling over your 401(k) distributions from one retirement account to another in what is called a “trustee-to-trustee transfer.” Rollover your 401(k) to a Roth IRA. This strategy is a little trickier because you will have to pay income tax on the balance transferred to the Roth IRA. The timing of a Roth conversion is very important, and the Boldin Retirement Planner can show you the best time to make the conversion if it’s right for you. You can find more strategies for managing your 401(k), 403(b), and IRA taxes in our article 6 Strategies to Manage Required Minimum Distributions (RMDs).

401(k) Withholdings

The IRS requires custodians of 401(k), 403(b), and other qualified retirement accounts to withhold 20% of periodic distributions. Like with pensions and annuities, 20% withholding may be too much or not enough. You can elect to change the amount of withholding by filling out IRS Form W-4P and submitting it to your plan’s administrator.

HSA and 529 Accounts

Health Savings Accounts (HSAs) and 529 education savings plans are great options for letting your money grow tax-free. Though these savings plans don’t withhold taxes from distributions, they do have some important tax advantages. HSAs are tax heroes three times over. You pay no tax on the money you contribute, the money grows tax-free, and when you take money out to cover health-related expenses, you pay no tax on it. Find out everything you need to know about HSAs in our article What is a Health Savings Account (HSA) and Why It’s a Great Retirement Savings Option. 529 savings plans are great for helping your family. 529s are almost as good as HSAs in terms of tax benefits. Though you can’t deduct contributions to 529s, the money grows tax-free, and the withdrawals are not taxed if the money is used for educational purposes.

Withholdings

There are no federal or state tax withholdings for these accounts because the money you take out is always tax-free — as long as the money is used for the purpose mandated by the account type.

Passive Income from Real Estate or Dividends

Passive income is great for retirees and anyone interested in financial independence. You work your own hours and all the profit is yours. Passive income from real estate is taxed as regular income at both the federal and state level. Fortunately, the Boldin Retirement Planner takes federal and state taxes into consideration when it calculates your retirement income and tax burden. There are some nuances to the taxation of dividend income that we explore in our article The Pros and Cons of Dividend Stocks for Retirement Savings. Dividends received in tax-advantaged accounts, like IRAs, grow tax-free, though they are subject to taxation depending on the type of account you have (for example, a traditional versus a Roth IRA).

Passive Income and Dividend Withholdings

The best and simplest way to withhold taxes from passive income is to create a separate savings account and deposit 35% of all your passive income into it monthly. That way it will earn a little interest, and if you don’t wind up in the top tax bracket, the leftover money becomes your emergency savings fund.

Retirement Jobs

Working in retirement is a great way to stay active and earn some money on the side. Explore your many options with our article Jobs for Seniors: What Are the Best Jobs After Retirement? Similarly to the situation with passive income treated above, tax strategies for working in retirement depend on a lot of factors, for example:

• Are you working part-time for a corporate employer or are you self-employed?
• Are you getting paid as a freelancer or contract laborer on a 1099?
• Are you a sole-proprietor of your own small business?

In most of these cases, you are responsible for withholding your own taxes. Like passive income, the simplest and best strategy is to put 35% of your earnings into a savings account the minute you receive it. At tax time you will have a reserve of money to pay your tax bill, and if you are able to take deductions that lower your bill, you have also grown your emergency savings fund.

Working Withholdings

Having a job — a side-hustle or a gig or part-time position — counts as income, and any income you make from a job is, well, taxable income. As such, it is subject to the usual rules for federal and state income tax withholding. Of course, not all jobs withhold money from your paycheck. Freelance and contract jobs paid on a 1099 don’t withhold taxes, so the burden is on you to pay income and payroll tax. What is IRS Form 1099-NEC? Form 1099-NEC is the form an employer pays a contract worker who is not a full-time employee. People who do freelance work, like writers or computer programmers, and people who do “gig-economy” work like driving Uber cabs, are considered contractors. Their income is reported to the IRS by their employer on a 1099 form.

Planning Taxes with the Boldin Retirement Planner

The tax planning functionality in the Boldin Retirement Planner is incredibly powerful. While not a replacement for a tax professional, the Planner gives you a credible estimate for what you will pay in taxes each year — for the rest of your life and helps you see opportunities for reducing this burden. This sophisticated system:

• Automatically estimates your federal and state gross taxable income, deductions, and estimated taxes by year using the latest available tax tables and rates.
• Allows you to set different levels of income throughout retirement to approximate your tax bracket for each year. Additionally, it allows you to specify if annuity and/or pension income should be taxed (at both the federal and state levels).
• Automatically estimates how much of your Social Security income will be considered taxable based on the state you live in and your gross taxable income by year.
• Lets you specify how much of your savings are in different types of taxable and non taxable accounts and it automatically calculates the tax liability (or lack thereof) for each account, as well as tax deduction handling of contributions. And, if you live in a state that doesn’t tax retirement savings withdrawals, the Boldin Retirement Planner supports that, as well.
• Estimates required minimum distributions (RMDs) from retirement accounts starting at age 72 – a significant lever when it comes to tax liability in retirement.
• Allows you to choose if investment returns on after-tax savings should be treated as long-term capital gains or ordinary income.
• If you are considering a Roth conversion, the calculator will estimate the tax hit in the year of the conversion as well as the benefit down the road when you draw from the Roth account.
• If you are planning on relocating, the system factors that in and uses your new state tax rates for the years following your planned move.

For a full listing of the current tax rules in the system, which are regularly being updated, visit the Assumptions page after logging in.