You will most likely receive income in retirement from various types of investments. However, the federal and state taxation on these different types of investments can vary and can be detrimental to your tax strategy. Because of the complexities involved with investments and taxation, it is important to seek out professional tax advice when necessary. Here is a summary of the federally taxable sources of retirement income. Once again, state taxation varies by your state of residence.
Some people will pay federal income tax on their benefits; however, no one will be taxed on more than 85% of their benefits. Those who will pay taxes include individual filers with a combined income greater than $25,000, joint filers with a combined income greater than $32,000, and married couples who file separate tax returns. When completing your federal income tax return, your benefit statement (Form SSA-1099) can help you figure out the correct taxation of your benefits. This form will show the amount of Social Security benefits you received during the previous year.
Taxable pension payments are taxed as ordinary income with the assumption that you, the participant, have not made any after-tax contributions toward the pension plan. If you did make after-tax contributions, then your pension payments will be partially taxed. The IRS treats qualified and nonqualified pensions differently. The Simplified Rule is applied to qualified pension plans and the General Rule is applied to nonqualified pension plans. Under the Simplified Rule, all contributions made by an employer are taxable during the same year distributions are made. Under the General Rule, the IRS provides favorable tax treatment to non-qualified pensions and states that only returns that exceed the cost basis will be taxed as ordinary income.
Qualified dividends are typically taxed at your capital gains tax rate. To be recognized by the IRS as qualified, such dividends must be paid out by a company that trades on a regulated U.S. exchange or a company that is eligible to receive certain benefits under the U.S. tax treaty. These qualified dividends must also be held at least 61 days of the 121-day period that began 60 days before the stock's ex-dividend date (the date you officially receive the dividend payment). Some dividends on preferred stock will require a longer holding period. The taxes you would pay on qualified dividends will depend on your tax bracket. Those in the 10% and 15 % tax brackets will not pay any taxes; tax brackets of 15% and up to 39.6% will see a 15% tax rate; those in the 39.6% tax bracket will see a 20% tax rate. Nonqualified dividends are taxed a normal ordinary income tax rate, regardless of your tax bracket.
Real estate investment trusts
Real estate investment trusts (REITs) are companies that own and/or finance income-producing real estate. These companies are required to distribute at least 90% of their taxable income in the form of dividends to shareholders, so shareholders are ultimately liable for paying these taxes. For the most part, REIT dividends are taxed as ordinary income.
Master limited partnerships
Master limited partnerships (MLPs) are publicly traded partnerships that combine the tax benefits of a partnership with the liquidity of a publicly traded corporation. Ownership is issued in the form of units and not shares. While tax treatment of MLPs can be quite complex, distributions are generally tax-friendly for investors because income is taxed at the partnership level before it is passed through to unitholders. These distributions are reported using a K-1 instead of a 1099 form. It's important to note that the tax benefits of an MLP cannot be enjoyed if held in an IRA where they cannot be tax-deferred.
Bonds should be classified in three different types: government, municipal, and corporate. Depending on the classification, taxation of bond income can vary. However, income generated from any kind of bond is generally taxed as ordinary income for the year the income was received. Government bonds (i.e. Treasury bills, notes, bonds, TIPS, government agency securities, etc.) are only taxed at the federal level while tax-free municipal bonds are never taxed at the federal level. There are a few taxable municipal issues, such as Build America Bonds and these are taxed as ordinary income at the federal level. With the exception of municipal bonds, virtually all bond income is taxed at the federal level. Corporate bonds are liable for federal, state, and local taxes.
The tax treatment here depends on the type of IRA you have. Traditional IRA withdrawals will be taxed as regular income, assuming your plan was funded with after-tax dollars. This tax treatment applies to contributions made by either you or your employer.
With Roth IRAs, your withdrawals are tax-free as long as your are at least 59.5 years of age and the account has been active for at least five years. In the event you needed to withdraw money from your Roth IRA prior to being 59.5, an early withdrawal penalty would be applied only to investment gains portion of the withdrawal. So if you have to withdraw early, be sure it is from the contribution portion.
With annuity withdrawals, all earnings and interest (gains) must be withdrawn before the principal amount is withdrawn. The gains portion of this withdrawal is taxed as ordinary income where the principal portion is not. Similar to Roth IRAs, withdrawals made before you reach the age of 59.5 will come with a 10% early withdrawal penalty that is applied to the annuity's investment gains portion.
Tax-free retirement income
The good news is that not all retirement income is taxable.
Municipal bonds have proven to be useful in helping reduce one's taxable income, especially is cases for high-net-worth individuals. Generally, the interest income received from municipal bonds are free of federal income tax and in certain conditions, free of state and local tax, as well. For instance, if you reside in the same state as the bond issuer, your interest income may be tax free at the state and local level whereas living in a separate state may result in interest being taxed as income.
You may also find tax relief in retirement when it comes to proceeds from real estate. Income generated from reverse mortgages is not taxable because it is considered loan advances and not income. Contingent on certain IRS requirements, gains made from the sale of a home may be tax-free if the gain is no more than $250,000 for single people ($500,000 for married couples) and the seller had lived in the home for at least two of the last five years leading up to the sale.
The general taxation of investments can be at times challenging to grasp, and it's no surprise that professionals specialize in navigating this landscape on a client's behalf. What it all boils down to is income and the types of investments you generate this income from. By understanding the tax treatment of the underlying investment vehicle and its yielding payouts, you can avoid possible strategic mistakes come tax time.
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