Are Retirement Benefits Taxable?
Key Points – Are Retirement Benefits Taxable?
- What Is Tax Diversification?
- Understanding If and How Different Sources of Retirement Income Are Taxed
- Reviewing Roth vs. Traditional 401(k)s and IRAs
- How Do Pensions and Social Security Factor into the Discussion about Retirement Benefits Being Taxable?
- 16 Minutes to Read | 34 Minutes to Listen
Are Retirement Benefits Taxable?
Dean Barber and Bud Kasper review several tax planning strategies for various source of retirement income. Their goal is to answer the question, “are retirement benefits taxable,” and if they are, how so?
Determining If and How Your Retirement Benefits Are Taxable
There are so many income sources that you can have in retirement. Some will work for you better than others, and what works best for you might not work well for your best friend or neighbor (and vice versa). When it comes to your income sources in retirement, there’s one question in particular that you need to ask yourself. Are your retirement benefits taxable? It’s important to understand how your retirement benefits can be taxable as you’re planning for retirement.
Forward-Looking Tax Planning
Taxes is one of the most popular topics of our podcasts, radio shows, webinars, and articles, and for good reason. Taxes and health care costs tend to be the two biggest wealth-eroding factors for people in retirement. But did you know that you control your taxes better in retirement than during any other stage of your life? To do that, though, you need to have a good understanding of tax diversification and how to create a forward-looking tax plan.
Our Director of Tax, Corey Hulstein, recently joined our Founder and CEO, Dean Barber, on The Guided Retirement Show to talk about the advantages of tax planning during tax prep season. If you have a copy of our 2023 Retirement Planning Calendar, you would have realized that the IRS began accepting tax returns on January 24. Make sure you have a copy of our 2023 Retirement Planning Calendar so that you’re in the know about the many dates and events that can impact your retirement. You can download your copy below.
2023 Retirement Planning Calendar
Dean and Bud Kasper are going to help us review several tax planning strategies for various source of retirement income. Hopefully, this will help us answer the questions—are retirement benefits taxable, and if they are, how so?
Rules Regarding Taxes Can Get Easily Twisted
The quick answer to “are retirement benefits taxable” is, probably, but not always. It depends on your unique situation. While we mentioned that you can control your taxes in retirement better than at any other point of your life, that doesn’t mean that it’s not complex. Because it is very complex. We’re going to look at the following retirement benefits and assess if and how they’re taxable:
- Traditional IRAs and 401(k)s
- Roth IRAs and 401(k)s
- Social Security
- Selling stocks, bonds, and mutual funds
- Savings bonds
- Home sales
- Life insurance proceeds
“A lot of these different sources of what could be taxable income don’t play very nice together on a tax return. When we start talking about taxes in retirement, we always say that during retirement, you can control your taxes unlike you did during your working years. You do that with a forward-looking tax strategy. And to have a forward-looking tax strategy, you really need to have the complete financial plan done in advance.” – Dean Barber
When you’re still working, you know what your paycheck is going to be each year aside from maybe getting a bonus. Once you’re in retirement and don’t have that type of set income coming in, your tax planning strategy suddenly has a lot of meaning for you. So many people go into retirement and pull money out of their 401(k) and it’s 100% taxable. Well, there are a lot of ways around that to mitigate some of those taxes. If you’re not making yourself aware of it, then you’re missing out on opportunity. Along with assessing if and how the retirement benefits listed above are taxable, make sure to download a copy of our Tax Reduction Strategies Guide below.
Download: Tax Reduction Strategies Guide
Are Retirement Savings Accounts and Employer Retirement Benefits Taxable?
Traditional IRAs and 401(k)s
This is where tax diversification becomes so important. You need tax diversification just like you need diversification within investments.
As we run through these retirement benefits and determine whether and how they might be taxable, let’s start with traditional IRAs and 401(k)s. The money that comes out of traditional IRAs and 401(k)s is taxable.
To get the money out of a traditional IRA without a 10% penalty, you need to be 59½. Once you’re 59½, you can begin to take distributions or withdrawals out of your traditional IRA. That income that you take out of the traditional IRA will show up as ordinary income. You’ll have your federal tax and your state tax if you live in a state where there’s a state tax. This is not going to be subject to any type of FICA tax or Medicare tax because this is money coming out of an IRA.
The traditional 401(k) is a different story. There’s a little bit of a nuance to getting money out of a 401(k). If you happen to work for a company and you separate service after age 55 but aren’t 59½ yet, you can still make withdrawals from that 401(k) without incurring the 10% penalty. Otherwise, it’s taxed exactly like the traditional IRA.
Lump Sums and the 72(t) Rules
One thing you do need to be aware of are the 72(t) rules so that you don’t accidentally breaking them if you want to access money from your IRA before 59½ with the 10% penalty. That can be cumbersome, especially if an emergency comes up and you have no other source of income. But with a traditional 401(k), you can do that in a lump sum. There aren’t rules with that as long as you separate service after 55.
Inherited IRAs and 401(k)s
Believe or not, but how retirement benefits are taxable can get much more complicated when it comes to inherited IRAs and 401(k)s. Dean and Bud explained late last year how complicated the inherited IRA rules are because of the SECURE Act. Some of those rules changed while other rules didn’t when SECURE 2.0 passed in December.
“If you’re going to leave money in an IRA to somebody else or if you think you’re going to inherit IRA money from somebody else, you need to understand that the rules have changed dramatically. They’re very complex and if not followed, you will be subject to some sizable penalty taxes.” – Dean Barber
Roth IRAs and 401(k)s
Next in our discussion about whether retirement benefits are taxable, we’re going to cover Roth IRAs and 401(k)s. Dean and Bud both believe that the best part of the tax code that’s ever been written is the section that surrounds Roth IRAs and Roth 401(k)s. Essentially, you’re putting your money in after you’ve already paid tax, and then all the earnings and future distributions come out tax free. That’s right, tax-free.
There are many instances where we’ve talked to people for the first time and they’ve only saved to a traditional 401(k). And for the longest time, companies didn’t offer the Roth 401(k) option. But many of them do now. If you do have the Roth option, how do you decide whether to go with it or the traditional?
“You need to consider that you must pay the tax first when you put a contribution into a Roth 401(k) plan. A lot of people say, ‘I don’t want to do that. That’s just more tax that I need to play.’ Well, they’re not looking into the future and assuming that their tax bracket will be nearly the same as it is now. Most of the time, it will be that way. Having that tax-free income at that time from the Roth is a blessing. You just paid it forward to yourself.” – Bud Kasper
How the Roth Factors into the Tax Diversification Picture
The Roth plays a big role in having good tax diversification. You want to some money in taxable, tax-deferred, and tax-free accounts. To determine how much you need to have in each bucket, you need a financial plan that can show you your probability of success.
Are Retirement Pension Benefits Taxable?
Let’s move on to pensions as we continue to ask, are retirement benefits taxable? While the Roth 401(k) has become a more common option, the popularity of pensions has gone in the other direction in recent years. For the most part, pensions have died off in favor of the 401(k) plan. A pension plan is essentially a way for you to continue to get a paycheck after you retire. It’s funded by your company. If you work for the federal or state government, you’re a teacher, or work for the fire or police department, you might have a pension.
Pensions are taxed as ordinary income. There are some exceptions in some states where some of the pension income may not be taxable in the state in which you live even if there is a state income tax. That’s all very specific to the state. But suffice it to say, pensions are taxed as ordinary income. So, you’ll have your federal and you’ll have your state, if applicable, and then your pension(s) will add to whatever other ordinary income you have.
Lump Sums and the Fed Funds Rate
Pension plans have been hit hard for much of the past year. If somebody has a pension and their company has an option for a lump sum, that lump sum can be rolled into an IRA without current taxation. That lump sum coincides with the Fed funds rate. And since the Fed funds rate has gone up, that has taken away some of the amount.
Bud recently met with someone who had approximately a $1 million lump sum that was reduced to close to $800,000 because they weren’t aware of the impact of the rising Fed funds rate. It’s no doubt a painful pill to swallow, especially with how difficult it is to understand.
“When a pension fund calculates their amount of money that they need to have in the fund to fund your future payments in the monthly pension, the lower interest rates are, the higher the amount of money they need to have in that pension fund to meet those obligations. Once interest rates start rising, they can apply a higher interest rate to that initial lump sum. So, they don’t need as much money in there to fund it. That’s why the pension lump sums are reducing.” – Dean Barber
You’d have to get to something where you were going to do a 6% or 7% distribution stream to meet the same amount of income that the monthly pension was going to get. So, if you have pensions, just know that they’re complicated. It’s not as simple as just looking at it and seeing your monthly amount. You need to make sure that you understand all the different options.
That leads us into to talking about another type of pension that just about every American has. We’re talking about Social Security. Social Security is a form of income. You put money into it every paycheck for as long as you work and your employer makes a dollar-for-dollar match. So, make no mistake about it that what’s coming from the Social Security Administration is the money that you have contributed to Social Security. This is not a gift.
Social Security is what people count on in retirement. But you need to understand that Social Security isn’t a tax-free benefit unless it’s your only source of income. It becomes taxable at certain levels. In the retirement planning process, your CERTIFIED FINANCIAL PLANNERTM Professional should be working with a CPA to confirm what the tax strategy is going to be going forward. They will make a notation that if you go over those particular thresholds, it’s going to make up to 50% or 85% of your benefit taxable.
To understand all the nuances of Social Security and what to think about in terms of when you’re going to claim your Social Security, download a copy of the Social Security Decisions Guide below.
Download: Social Security Decisions Guide
There’s a formula it’s called the provisional income formula. That provisional income formula takes 50% of your Social Security benefit and adds to it any other form of taxable income, including that of municipal bonds. The only form of income that isn’t counted in that provisional income rule is distributions from the Roth IRA. That’s part of why Dean and Bud spoke so highly of Roth IRAs.
Are Benefits from Selling Holdings in Retirement Taxable?
Selling Stocks, Bonds, and Mutual Funds
They also can’t stress enough about the importance of looking at all your sources of retirement income together and understanding what you need to do the things that you want to do in retirement. It’s all about setting yourself up so that you can have the right distribution strategy from all the different potential income sources to pay as little tax as possible throughout your full retirement years. Next, we’re going to look at selling stocks, bonds, and mutual funds.
You also need to keep long-term capital gains in mind here. It’s either zero if you’re in the 15% bracket or below. It’s 15% if you’re above that bracket, and then go up to 20%. You might not have any tax depending on your basis is in whatever you’re selling. But it is a more favorable rate than ordinary income in most circumstances. So, you need to understand how to control this and do it to your advantage.
“If you understand what your tax status is going into the end of the year, there might be room for you to take some long-term capital gains at that likely tax rate of 15% or 20%. You might be better off taking it now or be better off waiting until the new year and coordinate that in your plan to minimize the amount of tax you would possibly pay.” – Bud Kasper
Adjusted Gross Income
As a reminder, those are the federal income tax rates on capital gains. If you get an adjusted gross income and it’s high enough, you can also be subject to the ACA tax on those capital gains or qualified dividends, which is an additional 3.8%. The maximum capital gains rate when you combine the ACA tax with the capital gains tax is 23.8% at the federal level. Some people aren’t aware of that and sell something and get a $3,000 or $4,000 capital gain.
Surprises That Lead to Retirement Benefits Becoming Taxable
Let’s say that you’re in that 15% bracket or below and therefore allowing those capital gains to be tax-free. Then, you decide to make a distribution out of your IRA, which is taxable and puts you up into the next tax bracket. Those capital gains are now taxed at 15%.
“That’s why I was saying that all these different assets that someone can have and places where they can get income from don’t play nice together. If you don’t understand the complexities of how one of these types of income in retirement can affect another, that’s when people wind up overpaying their taxes in retirement. It’s not because they didn’t do their tax return correctly. It’s because they didn’t understand the complexities and they missed opportunities. Planning opportunities are the biggest ones.” – Dean Barber
If you’re selling stocks, bonds, or mutual funds and you have capital gains, you need to make sure that you know exactly what that capital gains tax is going to be. That capital gain could also cause more of your Social Security become taxable. So, it’s critical as you head toward retirement that you develop a good forward-looking tax strategy.
Circling Back to the Roth or Traditional Debate
This is a time when you really need to work with a CPA and CFP® Professional together because there’s too many people that Bud refers to as “stock jockeys.” They don’t have a lot of knowledge in terms of taxation and all that.
This goes back to figuring out when it’s best to save to traditional versus Roth. Bud is a big believer in the Roth and eliminating all the capital gains and ordinary income. When you’re in that after-tax contribution that you’re putting into the Roth, you never need to worry about the taxes. But if you’re doing pre-tax.
Let’s say you’re 50 years old and are going to retire at 65. We don’t know what the tax brackets will be like 15 years from now, so that’s another reason why Bud is all for eliminating Uncle Sam as quickly as possible and taking that unknown away from your larger plan.
Dean is also a big fan of the Roth but does think there are times when it makes more sense to do the traditional. He wants to make sure that before telling someone to save to the Roth that it’s the right thing for them to do.
The Power of Roth Conversions
For example, let’s say you’re 60 years old, making $300,000 a year, and have all your debt paid off. You know that when you get into retirement, you’re only going to need $100,000 a year to support the lifestyle you want. If put you it into a traditional 401(k) and get the tax deduction at that much higher rate, once you retire, you can start to do some Roth conversions.
You’re ultimately going to get it to the Roth, but you can get it there at a much lower tax rate. Dean knows that everybody isn’t in that scenario, but that’s one example of why he believes that saving to the traditional side can make some sense at certain times.
Studying with America’s IRA Expert
While Dean and Bud might agree to disagree for a few cases of when to save to traditional or Roth, they both are extremely thankful to study with America’s IRA expert, Ed Slott. They’ve been studying IRAs and how they’re taxed with Ed since 2005. Even after 17-plus years of studying with Ed, there are still things that they’re learning about the tax code. Ed has been featured multiple times on The Guided Retirement Show and in several of our articles, so makes sure to see what insight he has to offer on retirement benefits being taxable.
Beware of Phantom Income
Before we move on from stocks, bonds and mutual funds, there is something called a phantom income that is sometimes within mutual funds that we want you to be aware of. The phantom income is capital gains within the fund itself that will be taxable to you. So, 2022 could have been a year where you had capital gain distributions from a mutual fund where that it lost money during the year. Therefore, you end up with less money at the end of the year and still need to pay taxes on the capital gain distribution.
If you own individual mutual funds inside of a taxable account, that’s something that you need to be aware of. And that happens whether you’re in retirement or nearing retirement.
Now, let’s move on to dividends. Dividends from qualified stocks can have the same tax treatment as capital gains. But dividends from a bond mutual fund are taxable as ordinary income. So, there is a difference between a qualified dividend and an ordinary dividend.
Those are things that we look at and talk about as we create strategies to produce income in retirement. If we can produce income with qualified dividends and get the capital gains treatment, there is a great advantage to that.
You can go to irs.gov and find form 1099-DIV. That’s where you’re going to find out whether you have any qualified dividends. It’s listed in box 1B. A lot of people don’t know whether they have qualified dividends, and there’s some preferential treatment with that. Understanding that is beneficial.
We want to finish our article on whether retirement benefits are taxable with talking about savings bonds, sale of home proceeds, and life insurance. Savings bonds aren’t treated like other traded securities such as stocks and bonds. The interest on savings bonds is taxable on the estate or on the deceased’s final tax return. The beneficiary must pay taxes on those savings bonds’ interest after the date of death. So, it’s kind of a postponement of the taxes that are due on that for people that are using that as part of their portfolio.
Also, it’s possible to avoid paying taxes on inherited savings if you qualify for an educational exclusion. Very few people have that come up, but it’s one of the points to know.
If you bought a savings bond, own it, and are trying to use that as part of your savings for the future, you’ll see that it’s a tax-deferred vehicle just like an IRA. All the accrued interest inside that savings bond won’t be taxable until you cash the bond out.
When you cash the savings bond out, any value in the bond that’s above what you paid for it is treated as ordinary income. It will look just like income coming out of a traditional IRA, traditional 401(k), or pension. The only thing it wouldn’t be subject to is any state or local income taxes. But federally, it would be fully taxed.
Another thing that a lot of people will do in retirement is sell their primary residence. Oftentimes, those people will go into a community and rent. If a married couple sells their primary residence with a gain in value of more than $500,000, anything over that amount will be treated as a long-term capital gain if they owned the home for at least a year. You may qualify to exclude up to $250,000 of that gain from your income, but $500,000 is the ultimate level.
“The proceeds from a home typically are not taxable unless you exceed that $500,000 mark for a married couple or $250,000 for a single individual. It’s not something that happens all the time, but we’ve seen people sell a home and maybe buy another home. Just keep in mind that any gain in excess of that $500,000 is going to be subject to capital gains.” – Dean Barber
We’re going to wrap up this discussion on whether retirement benefits are taxable by talking about life insurance. Dean and Bud have known a lot of people over the years with different companies that have said to put money into a life insurance policy while you’re working. Then, you get tax-free income from it when you retire.
While that might be true, not all policies are created equally. If you go down that path, tread lightly, be very cautious, and be very skeptical. Don’t do something with somebody that just represents one type of insurance policy. You need to look around because there are multiple insurance companies that have different insurance policies that accumulate cash value and they have different rules for getting that money out in the future. The differences can be stark when it comes to the different types of policies.
“Insurance is generally part of anybody’s financial plan. When you’re younger, you get the term insurance because it’s inexpensive and it takes care of your family if you have an unfortunate event that would take you out of the family equation. Today, retirees are more concerned about nursing home care. Therefore, they’re looking at policies that can provide two elements of interest. One would be simply the death benefit associated with that, which would be passed on with no taxes to the heirs at that time. Then, the other side of the equation is taking care of what your medical needs could be. There’s a huge evaluation that must go into that.” – Bud Kasper
Critical Care Rider
The proper term for that is called the critical care rider that some policies have the availability of. That critical care rider allows you to access a portion of the death benefit to pay for long-term care expenses.
When you access that portion of the death benefit to pay for long-term care expenses, it’s tax-free. Proceeds coming out of an insurance policy to the beneficiaries are tax-free in most instances. Depending upon how the insurance policy is owned, it could become taxable in the future.
“This not only becomes part of your retirement strategy. It’s part of your estate planning strategy. Going over estate taxes and how money transfers from one generation to another is another subject that is just as complex as how retirement benefits can be taxable.” – Dean Barber
Getting to the Bottom of How Your Retirement Benefits Can Be Taxable
The bottom line is to understand that can control your taxes in retirement more so than you can during any other time of your life. It requires a coordinated effort with a CERTIFIED FINANCIAL PLANNERTM Professional and CPA to build your plan and then look at it from a tax perspective.
It’s critical to have a team of professionals that helps you build and update your plan throughout the life of the plan. We’re giving you the opportunity to start seeing what that plan can look like by granting you access to our financial planning tool. You can use our industry-leading tool at no cost or obligation to begin building your plan by clicking the “Start Planning” button below.
As Dean and Bud mentioned, understanding how retirement benefits can be taxable isn’t easy. Our team is here to give you additional clarity about how your retirement benefits could be taxable. To schedule a 20-minute “ask anything” session or complimentary consultation with one of our CFP Professionals, click here. We can meet with you in person, virtually, or by phone depending on what’s easiest for you.
While we’re patriotic, we don’t want to pay a dollar more in taxes than absolutely need to. It all begins with a financial plan and forward-looking tax plan.
Are Retirement Benefits Taxable? | Watch Guide
Introduction – KC in the Super Bowl Again!: 00:00
Planning a Tax Strategy: 02:25
Traditional IRAs and 401(k)s: 04:30
Roth IRAs and 401(k)s: 08:00
Social Security: 13:37
Selling Stocks, Bonds, and Mutual Funds: 16:48
Savings bonds: 25:56
Home sales: 28:03
Life insurance proceeds: 29:29
Resources Mentioned in this Episode
- Taxes on Retirement Income
- Understanding Your Tax Allocation
- 7 Reasons Why Tax Planning Is So Important
- 6 Reasons Roth Conversions Could Work for You
Investment advisory services offered through Barber Financial Group, Inc., an SEC Registered Investment Adviser.
The views expressed represent the opinion of Barber Financial Group an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Barber Financial Group does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.