By Jim Terwilliger
One would think that by the time you reach retirement, your income tax picture would be simpler. After all, you’ve paid taxes throughout your working career. You’ve paid your “dues.”
While your tax bill might be lower (driven by lower income), your tax return generally is not at all simpler. In many cases, it is more complex.
This is due to the variety of income types most retirees see. These income streams are taxed differently. Further, some interact in a way that results in so-called “stealth” taxes, creating an additional tax bill beyond your marginal tax rate for incremental additions of income.
One example is found with Social Security at the lower end of the retirement income scale where additional income can increase the taxable portion of Social Security benefits. An example at higher incomes is where additional income can increase Medicare premiums and surcharges.
Let’s take a look at the myriad of income sources retirees might see and the variety of ways they are, or are not, taxed.
Income not subject to income taxes
Fortunately, not all income is taxable. Non-taxable sources include:
• Life insurance proceeds — Death benefits payable to beneficiaries are not taxable.
• Municipal bond interest — “Muni” bond interest is free of federal income tax and is not taxed at the state level if the issuing municipality is within the state. But this interest is included in modified adjusted gross income which is used to determine if a Medicare participant must pay a higher premium.
• US Savings Bonds (EE and HH) interest — While taxable by the federal government, such interest is not taxed by New York state.
• Qualified distributions from Roth IRAs or Roth 401(k)s — Certain rules need to be followed to avoid taxes and a penalty for non-qualified distributions. Regardless, distributions of contributions are not taxed, nor are they subject to early withdrawal penalties.
• Pensions from federal, state or local government — While taxable by the federal government, such pensions are tax-free in New York state.
Income partially taxed
Some retirement-related income sources are partially taxed. They include:
• Social Security — the portion of Social Security benefits taxed at ordinary rates can range from 0% to 85%, depending on other household income. Fortunately, such benefits are not taxed by New York state.
• IRAs, 401(k)s and deferred annuities containing post-tax dollars (basis) — Only the non-basis portion of distributions is subject to income taxes.
Income taxed at favorable rates
A good example here includes:
• Long-term capital gains and qualified dividends — Here the tax rate is 0%, 15%, or 20%, depending on overall taxable income. For 2019, long-term capital gains and qualified dividends are taxed at 0% for taxable incomes up to $39,375 for single filers and $78,750 for married. The top rate is 20% for taxpayers with taxable incomes above $434,550 and $488,850, respectively.
Income taxed fully at ordinary rates (10% to 37% marginal federal tax rates)
Examples that we know all-to-well include:
• Traditional employer pensions — Company pensions are taxed at both the federal and state levels. Pensions from federal, state or local governments, while taxable by the federal government, are not taxed by New York state.
• Earned income — W-2 income and net self-employment income is fully taxed. This income is also taxed an additional 7.65% for Social Security and Medicare contributions. If self-employed, the latter contributions are almost doubled since the taxpayer is both an employee and employer.
• IRAs, 401(k)s, and other retirement distributions containing pre-tax dollars — These distributions generally are fully taxed federally. An exception exists for IRA distributions going directly to qualified charities (qualified charitable distributions). These distributions are non-taxable for taxpayers older than age 70-1/2. Another exception exists in New York where the first $20K/person/year in distributions is exempt from state taxes for ages 59-1/2 and older.
A major disruption occurs at age 70 1/2 when required minimum distributions (RMDs) start. In addition to increasing the marginal tax rate, these distributions can also trigger additional “stealth” taxes through an increase in adjusted gross income.
Prior to age 70 1/2, there may be opportunities to enact partial conversions of IRAs to Roth IRAs at a relatively-low marginal tax rate, resulting in reduced RMDs later. Often, this can be enhanced by delaying the start Social Security to age 70 in order to maximize Social Security benefits and moderate taxable income during this time period.
Putting it all together
Given all these moving parts, we spend a lot of time on tax planning in our work with retired clients and their tax professionals. The objective is to develop a tax-planning strategy that maximizes the probability that their retirement goals will be met.
James Terwilliger, CFP®, is senior vice president, senior planning adviser, CNB Wealth Management, Canandaigua National Bank & Trust Company. He can be reached at 585-419-0670 ext. 50630 or by email at firstname.lastname@example.org.