When you’re in retirement, one of the biggest bites out of your spending money is income tax. What you are invested in, and where that investment is, can make a huge difference in whether your money will last as long as you need it. In this episode, we cover 10 ways your retirement income is taxed.
Make It Last with Victor Medina is hosted by Victor J. Medina, an estate planning and elder law attorney and Certified Financial Planner™. Through his law firm and independent registered investment advisory company, Victor provides 360º Wealth Protection Strategies for individuals in or nearing retirement.
Click the link below to watch the show:
Click below to read the full transcript…
Announcer: Welcome to “Make It Last.” Helping you keep your legal ducks in a row and your nest egg secure. With your host, Victor Medina, an estate planning and elder law attorney and Certified Financial Planner.
Victor J. Medina: Everybody, welcome back to Make It Last. I’m your host, Victor Medina. I’m so happy you can join us this Saturday morning. This is episode 51 of Make It Last and it is April 14th. Which means it’s getting close to Tax Day. So we’re going to talk a little bit about taxes today.
Even though it’s April 14th, you’ve got a little extra time. While the tax filing season began on January 29th, in fact, you have until April 17th, which is Tuesday to file your taxes. All those taxes that were due April 15th are due April 17th.
You might be wondering why that’s the case. I mean, April 15th is Sunday. You know you’re not going to mail anything out that day. All right? But why isn’t it on Monday?
Well, it turns out that there is a legal holiday in the District of Columbia called Emancipation Day, and so, because that falls on Monday the 16th, it pushes the entire nation’s deadline to April 17th.
If you didn’t like the District of Columbia before, you can certainly thank them now, because under the tax law, legal holidays in the District of Columbia affect the filing deadline across the country.
You now have two days. Now look, I don’t know about the size of your tax bill, but if it’s considerable, I don’t know whether two days is going to help you with paying the taxes. Do remember that there is a steep penalty for failing to file and a smaller penalty for failing to pay.
You’ll run some interest if you don’t give them all of the money that they’re due, OK? But you would owe them a lot more in penalties and interest if you didn’t file at all, so get that filing in.
This is Saturday the 14th so you have, like, three extra days. Get going. Get going. This is also my annual reminder that free tax preparation is never free. Never free.
Even though you are really happy that you don’t have to pay for TurboTax or Credit Karma or whoever else, remember ‑‑ if you’re not paying for the product, you are the product.
They’re reselling your information, and they are salivating at the opportunity of selling you some sort of financial product along the way. They could sell you investment stuff. They could sell you banking credit cards, whatever.
That’s what they’re doing with your information. I always recommend using a qualified tax preparation professional. It’s early business, not that early. You ought to be working with somebody that actually focuses their time on return preparation as opposed to somebody that’s doing it on the side for you.
It’s important to get the right information. It is taxes. We should spend some time talking about some tax related subjects for this show. Spent enough time on the last show being self‑promotional about who I am, and what I do.
This time, when you package the education in, we’re going to be square in that realm of legal and financial planning. It is all about taxes, and taxes in retirement. When you retire, it can certainly feel fun to be thinking about all the cruises, the golf you’re going to play, and the meals that you’re going to be eating out.
Certainly, if you look at retirement as the reward for a life well‑spent, and saved, enjoy. One of the things you can absolutely do to help yourself out is to be thinking about taxes. Before they’re due and before they hit you. Proactive income tax planning is a hallmark of the subjects that we teach in our firm, the way that we talk to people and also in this program.
The right time to be doing tax planning is in the year in which you caused the taxes, not afterwards. This is not a January through April activity in the month after you’re done paying taxes.
This is something you ought to be thinking about doing far earlier than that. What I’m going to do is, I’m going to cover 10 different ways that your retirement income gets taxed. If it’s going to be news for you, on each one of these, I don’t know what to tell you.
Taxes are coming. That’s the one person you can’t escape. Accumulator effect of your income taxes really can take a bite out of your retirement. One of the smartest things you can be doing, and make sure that you make it last, is to be thinking about your income taxes proactively.
Unless you live in one of the seven states with no income tax at all, you got to be thinking about your state income tax. We are based out of New Jersey, with a lot of clients in Pennsylvania. I’ll talk a little bit about those state taxes, before we go into 10 different ways.
Realize that this is going to be determined by where you’re at. The story I love to tell is about my parents. Some of you have heard this story already. My parents were shopping around where they were going to be living, based on the income taxes.
They were two retired teachers. They really couldn’t control their income taxes, nearly as much as anybody else who has retirement income. Basically, they were people who had to be taxed on everything that came in. It looked like, and looked like, well, not wage income, but they couldn’t stagger their distributions out of multiple taxable accounts, or pre‑taxed accounts. That’s it.
They’re getting a pension. Because they’re getting a pension, they had to think about the state income tax. They went shopping for that. Now, some laws have changed. In New Jersey, one of the things that came about is that a couple of years ago, we had that 23 cents tax hike for gases. Gas, you’re buying gas.
That 23 cents was in exchange, by the way, for a number of other concessions on the taxes, including some stuff in it, inherited from the state tax. One of the biggest things that happened is we increased the threshold for retirement taxation, or taxation of retirement income, down from $20,000 up to $75,000 if you’re single individual, and $100,000 if you’re a married person.
One of the reasons why you need to attend to this proactive income tax is that in New Jersey, if you cross over that threshold by $1, you get taxed on the whole amount.
It’s important to make sure that you are looking at your income taxes, specifically in New Jersey, and doing whatever you can to stay below this threshold, so you don’t cause all of these taxation. You’ll be looking at your deductions in the way that you’re planning at.
I ended up reviewing my in‑laws’ tax returns. Because we took a second look at it, we basically took their New Jersey income tax from few hundred dollars to zero. We moved to the magic number below the threshold. That was really important for them.
In Pennsylvania, there’s flat tax on most income going in there. Those people that are in retirement actually don’t get taxed on that retirement income at all. Social security pensions, 401(k)s, IRA distributions ‑‑ these are not subject to income tax in Pennsylvania, a fairly friendly state for people that are looking retired.
That’s why we have so many New Jersey state workers with high pensions who leave the state as soon as they retire. Go over into Pennsylvania, pay a little bit less in real estate tax, but pay a lot less in income taxes.
Now, with the next tax law, could be that they could have escaped the income tax back over here, but who knows what’s going to be coming along in the new administration. We have brand new governor in New Jersey. Depending on how they get along with the Legislature and the Assembly, who knows we could be getting a new tax rollback of some of that.
Victor: Listen. When we come back, I’m going to go to the 10 ways that your retirement income is taxed, and let you understand it is important because we don’t want to go past that magic number in New Jersey. We certainly want go for federal numbers as well. Stick with us. We’ll be right back on Make It Last.
Victor: Welcome back to Make It Last. We’re talking about 10 ways your retirement income is taxed. If you are not aware about the new tax law that was passed just before the end of the year last year, it ended up changing a lot of the tax brackets that you might be familiar with.
Back in the day, you used to know that you could be taxed at 10, 15, or 25 percent. Now, those numbers are 10, 12, and 22 percent. The impact for proactive income tax plan, the value of it is still significant.
If you can get yourself underneath that 12 percent tax bracket, you’re saving 10 cents on the dollar. The jump from 12 to 22 is still 10 percent. It’s still the 10 percent that was there before. It’s still important to do.
We need to be thinking about different taxation on retirement income, and to the best that we can plan. If you’re not retired yet, you need to be thinking about this categories because there are ways to help your taxation when you retire, if you can think about these different categories of retirement income sources along the way.
First ones that we want to hit are traditional IRAs, are 401(k)s and are 403ps. Now, savor, love these taxes for retirement accounts because they don’t pay any taxes on their contributions. For the most part, they contribute under limit which means that they are pre‑tax and they come off of their tax bill in that year, and their growth in those accounts is tax‑deferred.
While the account is growing there’s no slow down, no anchor on that money as it continues to grow, it compounds and its growth. It only gets taxed when it comes out. People do forget that even though it went in tax‑free and even though it grew tax‑free when it comes out they have to start taking withdrawals and paying taxes on those withdrawals.
At some point in time, you have to take money out. If it is a traditional IRA, whether or not you’re still working, when you turn 70 and a half, you need to take those required minimum distributions and the percentage is 3.65 percent. Most people know it’s somewhere between three and four percent of what they need to take out every year.
There’s a little wrinkle, by the way, you may not be retired at age 70‑and‑a‑half and if you have a 401(k) with that company, whether or not you’re still contributing it, but if the money is still in that 401(k), and you’re still working, you can delay your required minimum distributions until you separate from service. At that point in time you have to take the money out.
You don’t have to take any catch‑up distributions. You don’t have to make up for the years that you didn’t take out, but you do need to take out in that year and there’s calculation for how much you need to take out. When you take out the money it is taxable.
What we need to remember is that it’s taxable at your ordinary income tax rates. Those are the rates that you paid when you are working or were working. If you think about those brackets that I just referenced at the beginning of the segment the 10, 12, 22, 24 percent those are the brackets that you’ll be paying this money out on every dollar.
Even though it was tax‑deferred for all these years, even though all the growth you might think of his long‑term, that’s a misnomer in this category. That’s not long‑term, this is taxed money that comes out, essentially, every dollar at that ordinary income tax rates.
You can watch that one, that’s the one that takes the biggest bite if you start to take more contributions out, that, pushes you into the next tax bracket along the way.
There’s another category of IRAs called Roth IRAs, some of you are familiar with those. Roth IRAs come with a big long‑term tax advantage. First of all, they are funded with after‑tax dollars. You pay the taxes on your Roth contributions upfront and in exchange, not only is the growth tax‑free, but so are the withdrawals.
Any money coming out of a Roth IRA is tax‑free money no matter how much it’s grown or how much tax it’s been deferred, or whatever your income tax bracket is. It’s all going to essentially be tax‑free money.
There’s one caveat to that, and you have to remember that you have to have held to that account for at least five years before you can take the tax‑free withdrawal.
We’re not going to get caught up in the Roth conversion discussion because I’m going to hold that for another episode. One of the reports it’s coming out. A lot of news outlets have picked up on this is that this might be the perfect storm for Roth conversion. We’re going to take the show coming up in the future and just dive into Roth conversions, how they make sense and why characterization stuff like that.
Whether it’s a contribution into a Roth or it’s a conversion, you have to hold that money for five years and then you can take it out tax‑free. If you don’t hold it for the five years you might have to take a 10 percent penalty on any withdrawals that you want out of there.
Really, the Roth IRA is a long‑term holding position you want that money to grow tax‑free. There’s no point in paying the taxes and the conversion and just take it back out again, might as well put it into a brokerage account for that.
In any event, Roth IRA, the category…Another category is and probably a big one for a lot of people is Social Security. It used to be, at once upon a time, like a fairy tale, Social Security benefits were tax‑free. That all ended when we had the Amendments to the Social Security laws in 1983.
Now, currently depending on your provisional income PI, up to 85 percent of your Social Security benefits are subject to federal income taxes.
To determine what your provisional income is, you take your modified adjusted gross income, that’s your MAGI and half of your Social Security benefits and all of your tax‑exempt interest.
Basically, what you’re looking at is if your provisional income is less than $32,000 or $25,000 for singles but $32,000 for married people, there is no tax on your Social Security benefits. If you’re somewhere between $32,000 and $40,000 as a married couple, or between $25,000 and $34,000 as singles, then up to 50 percent of your Social Security benefits can be taxed.
I did that quickly, I know that going numbers over the radio at podcast is difficult, but, listen if you’re between $32,000 and $40,000, or between $25,000 and $34,000 and you’re single, half of your Social Security is going to be taxable. If you’re above $44,000 or above $34,000 as a single individual then up to 85 percent of your Social Security is taxable.
That means not that you’re going to pay it at an 85 percent rate. That’s sometimes how people get really worried about how much money they’re going to get. You’re not going to be paying your Social Security 85 percent, but 85 percent is included in your taxable income as you calculate how much of your taxes you owe.
Victor: If you look at that number, you remember the chart, you figure out how much is your tax, 85 percent of your Social Security as if you make $10,000 a year $8,500 will get added into the number to figure out how much your taxes are going to be.
We’re going to take a quick break when we come back I’ll go through the other taxes and the other retirement income and you’ll have the full list of information. Stick with us. We’ll be right back on Make It Last.
Victor: We’ve been talking about retirement income specifically the way retirement income is taxed. I’ve got a number of them to go through, still left. We’ve talked about Social Security, 401(k)s, IRAs and Roth IRAs.
Let’s talk about pensions. Most of the time, pensions are funded with pre‑tax income, most of the time they’re funded by employers. That means that the full amount of your pension income is taxable.
If you want a handy guide to trying to figure out whether or not you’re going to be paying ordinary income tax, think about whether or not you would have paid it in the past, had you had access to that money.
For instance, in a pension, if that was your wage income, if it came from your employer, chances are you would have paid that at ordinary income rates. In this case, most of the time, your pension income is going to be taxed at those ordinary income rates. That’s 10, 12, 22, and 24 percent.
Next category of retirement income are stocks, bonds and mutual funds. We want to be careful here, we’re talking about a taxable account. As you know, you could own stocks, bonds and mutual funds in your IRAs, but what we’re really talking about is things that you held in a brokerage account, or what some custodians are calling a taxable account.
I know, that sounds weird, because everything’s taxable. In this case, we’re talking about money that was contributed after tax, and basically invested. If you’ve held these bonds, stocks and mutual funds for more than a year, you’re going to have them taxed as long term capital gains rates, and that’s, for most people about 15 percent.
There’s this little sneaky thing, which is that if you’re filing in the top bottom two brackets, if you are in the 10 and 12 percent bracket, then essentially, your capital gains are tax‑free up to the end of that bracket. Follow me, I know this is a little tough. The top of the bracket for 2018 is, as a married person, $77,000, roughly.
If you were making $50,000 of taxable income, you could sell $27,000 worth of gain, that was ordinarily long term capital gains, and pay zero. If you go above that, then your capital gains are at 15 percent. There’s another number for people that make more than that.
I want to be careful here, because the sale of bonds that you’ve held for a year is subject to long term capital gains, but the interest that the bonds pay is not. The interest that the bonds pay is realized at your ordinary income tax rate, and that’s similar to things like dividends.
We’re going to go through this, but I want you to understand that you have money being thrown off by your investments. Not from the sale of them, but by the investments themselves, and they’re going to have a different tax bracket than this long term capital gains that we were talking about.
That’s just, when you bought the bond for a $1,000 and you’re selling it for $1,010, that $10 is at long term capital gains. Another category is annuities. You’ve heard me go on about annuities here. I don’t say that they’re all good or all bad. I think that variable annuities for the most part are terrible.
Unless you’ve held them before, I think, the 1990s. Anything after that, bad product, we don’t like them. Regardless of which kind you have, there’s a good chance that some or all the money that you are receiving from an annuity is taxable.
That’s certainly the case if you bought the annuity in your IRA. Anything that comes out of your IRA is going to be taxable at an ordinary income tax rates. If you funded it with after tax money, then it depends on whether or not it is a return of your principal or not.
Annuities are a little bit different. They are subject, for the most part, to something called LIFO rules. LIFO stands for L‑I‑F‑O, it’s last in, first out. Which essentially means, for fixed index annuities and things like that, that the interest and the gain that you have in the annuity, that’s the last in, so it’s the first out.
Which means, the initial distributions are all taxable to you. When you get into the return of principal, then it’s essentially tax free. It’s a little bit tricky with annuities. I tell people, if you’ve held these things for a while, you want to count on the fact that distributions from the annuities are going to come out as essentially fully taxable money at your ordinary income tax rate.
That’s why I think sometimes that annuities make sense in IRAs. I know that’s against conventional wisdom if you do some research online. Part of the reason why, is because the taxes on the growth that’s in there, is the same taxes that it would be if it was invested.
We think about them from the tax perspective as being the same thing as an investment account inside of an IRA, and it makes sense. When you get money from a life insurance policy, that’s not taxable when it comes out as a beneficiary death claim.
For the most part, you want to think about it as tax‑free money, unless you’re in a certain category called the MEC, which is a Modified Endowment Contract. Which basically meant that you didn’t pay long enough into it, so you dig it with a single premium.
A little bit different life insurance, but most of the time, life insurance is tax‑free. Dividends are the profits that are gained from stock. There’s two different kinds of dividends, they’re taxed at different rates.
There’s qualified dividends, and those are taxed at long term capital gains rates. There are non‑qualified dividends, and they are taxed at your ordinary income rates, remember, those are the higher ones. Capital gains is 15 percent. Ordinary income is essentially at 10, 12, so on and so forth.
To be considered qualified, dividends have to be held for a minimum of 60 days during a 120‑day period. The ex‑dividend date is the date after the company distributes dividend payments to its shareholders. That 120‑day period begins 60 days prior to the ex‑dividend date, and there’s the whole rule for that.
Not going to matter, because when you get your 1,099, they’re going to tell you how much was qualified and how much was not qualified. You’re just going to figure out that out of the two categories, you’re going to have different rates on them.
Qualified dividends, essentially, long term capital gain. That’s pretty good, that’s 15 percent. The interest on municipal bonds gets taxed a little bit differently. If you think about the interest in municipal bonds, that’s not taxed at the federal level.
If the bond was issued in your home state, that’s typically immune from state income tax. If you have municipal bonds from outside of the state, then you will pay state income tax on that money. Even though there’s not tax federally.
Municipal bonds are generally thought of as tax‑free, but that’s on the federal level. That’s pretty good because depending on your ordinary income tax rate, that could be a 12, 22 percent savings off of that money. You want to think about which municipality and which state is issuing that, because it could be taxable in your state, depending on which estate it’s issued from, and where you live.
We have our last category, which is the interest that is generated from CD saving accounts and money market accounts. We have a lot of people that think about those accounts as their safety accounts for their retirement. They’ll ladder CDs, buy CDs that mature at different years.
They will have savings accounts that have a little bit of interest. A lot of times, if they’re going to have it in a savings account, they’ll probably put it in a money market account. Money market account will throw off interest a little higher than a savings account most of the time.
What we need to remember is that the interest on all of those accounts is taxed at you ordinary income tax rate. You want to be remembering that, because, again, those can those little sneaky items that cause you to go over your tax brackets.
Over your brackets if you’re planning on the federal level. Over your brackets when it comes to the amount of taxable income for the state. Remember, New Jersey, we want to stay under $75,000 if you’re a single person, or $100,000 if you are a married person.
We want to stay under those numbers because it will cause the rest of that money to be taxed. Little, little items like these CDs savings accounts and money market interests, those can cause you to go over. We want to think about these differently than we have in the past, because it’s a lot about our asset location strategies, as much as our asset allocation strategies.
Remember, asset allocation is to be diversified between products and investments. Assets locations, is where should we own these things? A smart investment advisor is going to tell you that for the most part, you should keep most of your bonds in your IRA accounts.
The interest that those bonds are throwing off, while it’s taxable in the sense that its interest, it’s not taxed to you until you take that money out. We’ll be able to keep the interest growing in those accounts, but not have to pay taxes on it.
We only have to pay the taxes on the distributions that will come out off of it. Similarly, we want to take those mutual funds that are going to be long term capital gains, we want them in the outside IRA account ‑‑ the out of the IRA account, that taxable account.
We want to ensure that we get the capital gains treatment. If we took those mutual funds and we put them in the IRA, it didn’t matter that we held them for years, and years, and years. When they came onto the IRA, they would be taxed at ordinary income rates.
These tax location strategies are important because they can help you optimize how much money you’re living on. That is probably the most powerful planning strategies you can have. You can invest and have you short and mid‑term long buckets.
All of that stuff can be there, but the federal government taking a bite of how much you live on, that’s one of these things that most people don’t do proactive planning on. They do reactive planning on it, and then it’s too late.
We want to be managing this stuff ahead of time. You can be managing it for yourself, you can be managing it for an inheritance. That IRA, when you leave it behind, that money is taxable at ordinary income tax rates back to your beneficiaries. Likely, if they’re working they’re at a higher tax bracket than you.
Actually thinking about managing that for the inheritance section of it, making sure you pay taxes at a lower rate than they would, that’s smart tax planning too. Those are 10 ways that your retirement income is taxed. I hope you took notes.
If you didn’t, it’s OK, because you know that this episode, and every other episode that we’ve ever recorded, is available, and the podcast. You just go to iTunes, search for Make it Last with Victor Medina. You subscribe, and you can download this show and listen to it again in the future.
Download any of the past shows. Whether that’s on iTunes, or now on Spotify, or on our YouTube channel, you’ll be able to go back and listen to any of this stuff. By the way, we have a lot of our transcripts from the shows also online. They’re online at the website for the law firm, the financial firm, the radio show.
If you want to go back and re‑read this stuff, you can go to Medina Law Group, you can go Private Client Capital Group, you can go to Make It Last Radio. You can read the transcripts and basically go through this stuff in a little bit more detail.
Anyway, I hope you enjoyed this show. Thank you so much for joining us. If you like it, share it with another friend.
Victor: We’ll be back here next Saturday on Make It Last, where we help you keep your legal ducks in a row and your financial nest egg secure. Thanks so much for listening. Catch you next time. Bye‑bye.
Announcer: The foregoing content reflects the opinions of Medina Law Group, LLC and Private Client Capital Group, LLC, and is subject to change at any time without notice. Content provided herein is for informational purposes only, and should not be used or construed as investment or legal advice, or a recommendation regarding the purchase or sale of any security, or to follow any legal strategy.
There is no guarantee that the strategies, statements, opinions or forecasts provided herein will prove to be correct. Past performance is not a guarantee of future results. Indices are not available for direct investments.
Any investor who attempts to mimic the performance of an index would incur fees and expenses, which would reduce returns. All investing involves risk, including the potential for loss of principal. There’s no guarantee that any investment plan or strategy will be successful.
We recommend that you consult with a professional dedicated to your needs.