You may no longer be collecting wages once you retire, but that doesn't mean the IRS is through with you. Retirees often draw income from a variety of sources; some of these sources are exempt from federal taxes, while others are fully taxable, and still others may be taxed in part. It's important to understand what is and is not taxable and to plan your income sources accordingly, or your annual tax bill could become a serious burden.
Social Security benefits
The majority of retirees receive monthly benefits courtesy of the Social Security Administration. By itself, Social Security is not usually taxable. However, these benefits can become taxable under certain circumstances. If you have enough income from other (taxable) sources, you will exceed the Social Security taxation threshold and will be required to pay income taxes on some of your Social Security benefits. Types of income that count toward the threshold include dividends, interest, distributions from tax-deferred retirement accounts, profits from rental properties, wages, and taxable pensions and annuities.
Distributions from tax-deferred retirement accounts
When you save in a traditional 401(k) or IRA, you don't have to pay taxes on the money you put into the account, but you do have to pay taxes on the money you take out. Distributions from these accounts are taxed at your regular income tax rate, which is based on your adjusted gross income (AGI). AGI is your total taxable income minus certain adjustments, such as tuition expenses, health savings account contributions, and alimony. Your AGI and filing status will determine which tax bracket you fall into, and therefore what tax rate(s) you will pay.
Distributions from Roth accounts
Roth accounts are basically the opposite of tax-deferred retirement accounts. With a Roth account, you pay income taxes on the money you contribute to the account, but the money that comes out is tax-free (assuming you meet the qualifications, namely, that you have had the account for at least five years and are aged 59 1/2 or older). And because these distributions aren't taxable, they don't count toward your AGI.
Profits from selling investments
If you sell stocks, bonds, and other investments at a profit, you'll be required to pay capital gains taxes on that profit. Capital gains taxes come in two flavors: short-term and long-term. Short-term capital gains taxes apply to investments that you've owned for one year or less, and they're equivalent to your income tax rate. Long-term capital gains taxes apply to investments that you've owned for more than a year and are taxed at a lower rate -- 20% if you're in the highest tax bracket, 0% if you're in the 15% income tax bracket or below, and 15% if you fall in between. Long-term capital gains taxes will be quite a bit lower than short-term capital gains taxes no matter your tax bracket, so if at all possible, hang on to your investments for at least a year and a day before selling.
Putting the pieces together
If you plan out your financial moves instead of just taking money from this account or that one, you can reduce your tax burden significantly. For example, let's say your filing status is single and your Social Security benefits come to $2,000 per month. If one half your annual Social Security benefits plus your other taxable income equals $25,000 or more, then those benefits will become partly taxable. One-half your annual Social Security benefits would be $12,000, so if you keep your taxable income under $13,000 for the year, you won't pay taxes on your Social Security. Thus you could decide to keep your tax-deferred account distributions and capital gains below $13,000, and if you need more income than that, you could take a distribution from your Roth account. You could also sell an investment at a loss to generate some income, as the proceeds wouldn't qualify as taxable.
If you have a lot of different sources of retirement income, tax planning can get very complicated quickly. Consider getting advice from a tax planner who has experience with helping retirees. The IRS also has a free program called Tax Counseling for the Elderly, with volunteers who specialize in retirement-related tax questions. While these volunteers may not be quite as skilled or experienced as a credentialed tax-preparer, you can't beat the price.
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