Last Week’s Question of the Week: What percentage of income should you look to replace as you enter retirement? ANSWER: A common guideline is that you should aim to replace 70% of your annual pre-retirement income.
HOST: Today you’re covering an important topic in retirement planning which is understanding how the money will be taxed when we are retired. With the big tax bill change that was passed at the very end of 2017, can you explain to our listeners the difference in rates between paying Capital Gains tax vs. income tax?
KLAAS FINANCIAL: When we retire, taxes can be a factor and we do like to explain what to expect. Understanding fundamental differences between capital gains taxation vs. income taxation can be important. DISCLAIMER: We are not accountants, please check with your own accountant with regards to your own situation.
CAP GAINS vs. ORDINARY INCOME TAX
- First, let’s understand what cap gains are. It’s great when you have an after-tax investment, (not retirement accounts), and it appreciates in value, but the taxation may be capital gains taxation.
The IRS and many states assess capital gains taxes on the difference between what you paid for an asset — your basis — and what you sold it for. Capital gains taxes can be short-term or long-term, depending on how long you owned the asset. - Point of clarification: Short-term capital gains tax rates are equal to your ordinary income tax. There are now seven tax brackets for income tax (10 %, 12%, 22%, 24%, 32%, 35%,37%). Long-term capital gains tax rates, which usually comes into play on investments you’ve held for longer than a year, can actually be as low as 0% tax rate.
- With regards to the tax bill, and the Capital Gains rates: The new rules do not change long-term capital gains tax rates themselves — for the 2018 tax year they’re 0%, 15% and 20%, the same as 2017. But the thresholds have changed: Married, filing jointly, you will pay 0% for LT CAP GAINS up to $77,200; or Single, up to $38,600. Married, filing jointly will pay 15% for LT CAP GAINS up to $479,000; or Single, up to $425,800. Married will pay 20% over $479,000, single, over $425,800.
- IN SUMMARY: With an after-tax investment account, you will pay capital gains tax if your account has grown and if you take a distribution but never a penalty since these are not retirement accounts.
You will never pay a penalty on taking money out of an after-tax account unless it is an annuity. Distributions from after-tax annuities can cause a penalty if you are under 59-1/2, and remember that they are income taxable, instead of capital gains tax.
Interest, dividends and capital gains that occur in non-retirement accounts are reported on a 1099 form each year and you will pay tax on most of this type of investment income as it is earned. The exception would be any capital gains that fall into the zero percent tax rate – you don’t pay tax on that portion of capital gains.
HOST:What about paying income tax when we begin taking money from our retirement accounts?
KLAAS FINANCIAL:
Retirees will likely draw their income from a variety of sources. Some income may be exempt from federal taxes, some will be fully taxable, and others may be taxed in part.
- Taxability of Social Security income: Many people don’t realize that they will likely pay taxes on up to 85% of their social security benefit. This comes as a surprise to people who don’t realize that the IRS began taxing Social Security back in 1984 to help with the financing of Social Security. If your combined income is more than $34,000, up to 85% of your benefits could be subject to tax. And, if your combined income is less than $25,000, your benefits are not taxable at all. Married couples with combined income of less than $32,000 don’t pay taxes on their Social Security benefits. However, remember that the state of Wisconsin does not tax Social security and railroad retirement benefits.
- Pension income: Most pensions are taxable, and if you are collecting a pension in Wisconsin, your pension will be both state and federally taxable; however, some types of military pensions or disability pensions may be partially or entirely tax-free. The provider of your pension will send you a 1099 form at the beginning of each year that shows you how much of your pension is taxable. If you live in Illinois, your pension is NOT taxable by the state, just federally.
- Withdrawals from retirement plans: If a plan was funded with pre-tax dollars, whether by you or your employer, it will result in taxable retirement income when withdrawn. Expect pretty much all withdrawals from IRAs, 401(k)s, 403(b)s, SEPS, SIMPLES and other similar types of plans to be taxable. If you are under 59 ½, distribution of these monies from these plans will be charged a 10% penalty.
- What rate will you pay taxes? Depends on how much income you are taking. The more income you take as a result of your Social Security or pension, or to live your life, will determine the tax bracket that you will be paying taxes on as this is considered ordinary income tax. 10-37%.
- Distributions from Roth accounts are basically the opposite of a tax-deferred account. Assuming you paid tax when you put the money into a Roth, and you are 59 ½, and the account has been established for 5 years, you will not pay taxes on the growth when you take a distribution.
HOST:When I turn 70-1/2 and have to begin taking my RMDs from my retirement accounts, will I pay tax then? Can I avoid this?
KLAAS FINANCIAL: Yes, again according to your tax bracket, and the balance of the account from the previous year end close, you will be required to begin drawing out a percentage of your pre-tax monies from your IRA’s or 401ks (unless you are still working where the 401k plan is) and pay the taxes according to your tax bracket. How can you avoid paying taxes on your RMDs? You can currently donate your RMD’s (up to $100k per person, $200k per couple every year,) to a charity and avoid the taxes paid by you, and the charity pays nothing as well.
Catch C.J. Klaas and Maleeah Cuevas on Money in Motion every Thursday on Madison's 1310 WIBA from 8:05-8:35am.
