One of the most overlooked points, when retirees are calculating their living expenses, is the percentage of tax they will be paying on those retirement dollars. How you go about using your savings accounts can make a big difference in how much tax you will be responsible for.
It is generally believed that you should tap taxable accounts first, then tax-deferred accounts, and finally your Roth. For most retirees this makes sense. This changes if you have a lot of money in your traditional IRA or 401(k). When you turn 70 1/2 you will have to take required minimum distributions (RMDs) from those accounts. If the accounts grow too large - the minimum distribution could be large enough to put you into a higher tax bracket. This is avoided by making withdrawals from tax-differed accounts earlier.
Retirement assets are taxed in the following ways:
Tax-deferred accounts. Years of paying into these accounts and enjoying the tax benefits upfront of doing so leaves you with a painful distribution from these accounts. Withdrawals from traditional IRAs and your 401(k) will be taxed as ordinary income. At the top tax bracket.
Taxable accounts. Profits from sale of investments (stocks, bonds, mutual funds, and real estate) are taxed at capital-gains rates, which vary depending on the length of time you have own the investments. If you have held assets longer than a year, the long-term capital-gains rates are favorable. If you are in the 10% or 15% tax bracket, you will pay 0% on those gains. Most other tax payers pay 15% on long-term gains. Short-term capital gains are taxed at your ordinary income tax rate.
Roth IRAs. This is a fun account to withdraw from because as long as the Roth account has been open for 5+ years and you're 59 1/2 or older, all withdrawals are tax-free. You also do not have to take RMDs from your Roth account when you turn 70 1/2.
Social Security. Yes, you can be taxed on your Social Security benefits. Whether or not you’re taxed depends on your provisional income. Your provisional income is your adjusted gross income plus any tax-free interest plus 50% of your benefits. As of 2016 if your provisional income is between $25k and $34k if your single or between $32k and $44k if you are married, up to 50% of your benefits is taxable. If it exceeds $34k if you're single or $44k if you're married, up to 85% of your benefits is taxable.
Pensions. Assuming you made no after-tax contributions to the plan, payments from private and government pensions are usually taxable at your ordinary income rate.
Annuities. If you purchased an annuity that provides income in retirement, the portion of the payment that represents your principal is tax-free. Everything else is taxable. You should be told by the insurance company that sold you the annuity what is taxable. If you bough the annuity with pretax funds - different rules apply. If that happens, 100% of your payment will be taxed as ordinary income.
Financial circumstances are as varying as life circumstances be sure to connect with your Sorge tax team for information and guidance specific to your situation.
References: Kiplinger's Personal Finance. Yahoo Finance. Business Insider.