Is Your Retirement Income Taxable?

It is important to plan for retirement. Many people save additional funds outside of their pension or Social Security for retirement -- often using 401(k)s, Traditional IRAs, or Roth IRAs. However, most people forget to calculate for taxes that will be owed to the state and IRS on their retirement income. Is your retirement income taxable? Keep reading for additional details on how different forms of retirement income is taxed, so you can have a better understanding of exactly what your retirement take home pay after taxes will be. Do not get hit with an unexpected tax bill!

How are Distributions from 401(k)s Taxed?

Many retirees will supplement their retirement income with distributions from 401(k)s. Understanding how distributions from 401(k)s are taxed will help you better plan for retirement, as distributions from 401(k)s are taxable. Distributions from your 401(k) are taxed as ordinary income. This means the distributions are taxed at the same rate as income you receive from a job.

Example. John and Mary retired at 60 years old. They do not qualify for Social Security yet, so they decided to live on proceeds from John’s 401(k). They withdrew $50,000 from his 401(k) this year.

In the example above, under the new tax brackets under the new tax reform, John and Mary, if they file their taxes as married filing jointly, qualify for the standard deduction, and do not have any additional income, would fall into the 15% tax bracket. Since the tax rate is graduated, this means they will owe 10% on the first $18,650 or $1,865 and 15% or $1,043 on $6,950 ($50,000 - $24,400 (standard deduction for 2019) - $18,650 (taxed at 10% rate) = $6,950), the amount above $18,650. This means they would owe approximately $2,908 in federal taxes. This example is based on John and Mary qualifying for the standard deduction and does not account for other tax deductions and credits.

In addition to federal taxes, John and Mary would owe state taxes on the 401(k) distribution, unless they live in a state that does not have a state income tax. If you do not have state and federal taxes withheld from your 401(k) distributions, it is important you make quarterly payments to the state and IRS. If you do not, you could end up owing a penalty for not paying your taxes on time.

How are Distributions from Traditional and Roth IRAs Taxed?

Distributions from Traditional and Roth IRAs can be confusing when it comes tax time as they are handled very differently. Distributions from Traditional IRAs are taxed; distributions from Roth IRAs, typically, are not taxed.

When you contribute to a Traditional IRA, you receive a tax break. This means when you withdraw funds during retirement, the amount withdrawn will be taxed at your ordinary tax rate. Like the 401(k) example above, you would be taxed on the distributions from your Traditional IRA just like it was income from a job. Also, like distributions from a 401(k), if you make the withdraw early, before age 59½, you will owe a 10% tax penalty in addition to your ordinary tax rate.

Unlike Traditional IRAs, with Roth IRAs, you do not receive a tax break when you make contributions. This means when you withdraw funds, you do not owe taxes, as the distributions during retirement (after age 59½) are not taxed. If you make withdraws from a Roth IRA before age 59½, you will not be taxed or penalized if you do not take out more than what you contributed.

Example. Debbie contributed $5,000 in 1990 and $5,000 in 1995 to a Roth IRA for a total contribution of $10,000. Her Roth IRA investments performed well, and her balance totaled $22,000.

For her 55th birthday, Debbie wanted to purchase a new truck and thought about withdrawing the $22,000 from the Roth IRA. If she withdraws the full amount, she will be taxed and penalized 10% on the amount above her contribution, the $12,000 ($22,000 balance - $10,000 contribution = $12,000). If Debbie just withdraws the $10,000 and leaves the remaining $12,000 in the Roth IRA until she is 59½, she will not be taxed or penalized on any of the distributions she takes. This is one of the huge benefits of Roth IRAs, as it gives people a lot more flexibility.

The Bottom Line: Is Retirement Income Taxable?

It is important to account for taxes when you retire, so you do not get hit with a huge unexpected tax bill and can maintain your standard of living during retirement. Retirement should be about enjoying life and not stressing out over how you are going to survive.

A general rule of thumb is two-fold:

(1) if you receive a tax break when you make contributions to the retirement plan, like you do with contributions to your 401(k) and Traditional IRA, you will have to pay tax on the distributions when you retire and a penalty, if you take out the funds earlier (usually before age 59½); and

(2) if you do not receive a tax break when you make contributions to the retirement plan, like with contributions to your ROTH IRA, you will receive a tax break when you receive the distributions.

There are exceptions to these rules. To make sure you are properly prepared for taxes during retirement schedule an appointment with the tax professionals at Gudorf Tax Group. Do not get caught with a huge tax bill -- include tax planning as part of your overall retirement plan.