Tax Considerations for Retirement – Part I

When planning for retirement, on significant question is: “how much do I need to retire?” The answer is largely influenced by what type of retirement lifestyle you are planning to have. Is the plan to downsize and live modestly? Maintain the same lifestyle you were accustomed to while employed? Increase spending and live luxuriously while retired? Whatever the plan, there are three major sources of income that are an important part of the retirement cash flow mix:

(1)    Investment Assets – Brokerage accounts, savings accounts, limited partnerships, and other investments can be pulled from to fund retirement.

(2)    Pensions, Annuities, and Individual Retirement Accounts – While pensions are rarely offered to newly employed individuals; annuities have always been a way to purchase a pension-like income stream. However, for current savers, pre-tax and post-tax defined contribution retirement plans are generally the main components of retirement saving vessels in this area.

(3)    Social Security – Almost all Americans age 65 and older receive social security benefits and have the potential to account for a substantial portion of their retirement income. That being said, it would be prudent to make this a supplement to other retirement assets and not the whole plan given the current funded status.

The above sources assume the plan is to fully retire and only work if it is desired to do so.  For a growing number of Americans (20% over the age of 65 according to U.S. News) employment income is part of the income mix as well. Each of these sources of income has different tax implications.

Investment assets are the first part of the retirement cash flow mix. Below are investment assets from most to least tax efficient:

(a)    Tax exempt securities: Interest and dividends from tax exempt securities like municipal bonds and US treasury bonds allow income to pass to you tax free. Municipal bonds are tax free at the Federal tax level and only taxable at the state level if the investments originated from a nonresident state. Retirees relocating from another state should make sure their municipal investments are switched to NC bonds if they want to take advantage of completely tax free income. US Treasury bonds are taxable at the Federal level, but tax free in NC.

(b)   Capital Gains and Qualified Dividends: For a married couple, qualified dividends and long term capital gains are taxed at 0% as long as income does not exceed $73,800 for 2014. Even if income exceeds that level taxpayers can enjoy a 15% tax rate on capital gains and qualified dividends until income exceeds $250,000. Keep in mind short term capital gains are taxed at ordinary income rates.

(c)    Taxable Interest, Ordinary Dividends, and Partnership Income: All these are taxed at ordinary income rates. It is important to work with an investment advisor to make sure equity investments are considered “qualified” to avoid ordinary dividend rates. Taxable interest and partnership income are more of a matter of preference in the type of investment you want.

Individuals should start thinking now about tax efficiency in retirement. In the next part of this series we will discuss pre-tax and post-tax retirement plans.