Once you enter retirement, you may be living on a fixed income. You might think that your federal income taxes will stay the same or even be lower, but it’s important to remember that the IRS taxes different types of income at different rates. As you’re planning for retirement, it’s a good idea to understand at least the basics of how your income will be taxed.
Ordinary income. Withdrawals from some retirement accounts will be taxed as ordinary income, or at the same rate you would be taxed if you earned this money through work. Distributions from your 401(k), IRA, and some pension plans are taxed as ordinary income.
Tax-free income. If you previously invested in a Roth IRA, you will be able to take tax-free distributions in retirement. But in order for this income to qualify for the special tax-free status, the account must be at least five years old, and you must have reached age 59 ½.
Capital gains taxes. There are two types of capital gains taxes: short-term capital gains and long-term capital gains. An investment that you have held less than a year, and then sold at a profit, is classified as a short-term capital gain. One such example of a short-term capital gain would be buying and selling of real estate at a profit, provided you sell the property within a year of purchase. These gains are taxed as ordinary income.
Long-term capital gains are taxed separately. If you’re in the top income tax bracket, these gains are taxed at a whopping 20 percent! Any investment that you have held for more than a year before selling it for a profit will be classified as a long-term capital gain, so keep that in mind when you sell older assets.
Social Security taxes. In some cases, your Social Security benefits can be subject to federal income taxes. The formula for this tax is complicated, and is based on your overall taxable income. Up to 85 percent of Social Security benefits can be taxed, depending upon your tax bracket.
The 3.8 percent investment income surtax. This tax often comes as a surprise to retirees. This surtax is imposed on the lesser of net investment income or the excess of modified adjusted gross income (over a certain threshold). Keep in mind that not all of your retirement plan distributions are counted as net investment income. This is an issue to carefully investigate with your tax professional or finacial advisor, so that you can devise methods to protect yourself from excess taxation.