Month: July 2024

It’s important to know how common sources of retirement income are taxed at the federal and state levels.

BY KELLEY R. TAYLOR

LAST UPDATED 1 JUNE 2024

Navigating taxes in retirement can be challenging. Your tax situation may differ from your working years due to income and tax bracket changes. Required withdrawals from retirement accounts and income from other sources can also affect your tax liabilities.

That’s why it’s crucial to know how common sources of retirement income are taxed. Having this information can help you develop a tax-efficient strategy for your retirement years. 

Is retirement income taxable?

Comprehensive retirement planning involves considering various sources of income and understanding how they are taxed at the federal and state levels. But thankfully, there are several types of income the IRS doesn’t tax. For example, life insurance proceeds, long-term care insurance payments, disability benefits, muni bond interest, and alimony and child support are generally not taxable. Additionally, earned income in states with no income tax isn’t subject to tax at the state level.

Related: Types of Income the IRS Doesn’t Tax

Still, your tax planning should consider the tax treatment of income from annuities, pensions, Social Security benefits, and retirement savings accounts. You will also want to assess tax liability from various investments, earnings, and proceeds.

Here’s a breakdown of some common retirement income sources and a brief description of their federal tax implications. (More below on state taxes on retirement income.)

How some income in retirement is taxed

Social Security Benefits: Depending on provisional income, up to 85% of Social Security benefits can be taxed by the IRS at ordinary income tax rates.

Pensions: Pension payments are generally fully taxable as ordinary income unless you made after-tax contributions.

Interest-Bearing Accounts: Interest payments are taxed at ordinary income rates, but municipal bond interest is exempt from federal tax and may be exempt from state tax.

Sales of Stocks, Bonds, and Mutual Funds: Long-term gains (held over a year) are taxed at 0%, 15%, or 20% capital gains tax rates, based on income thresholds. Net investment income tax (NIIT) factors in for some taxpayers. at a rate of 3.8%.

Dividends: Qualified dividends are taxed at long-term capital gains rates; non-qualified dividends are taxed as ordinary income based on your federal tax bracket.

Traditional IRAs and 401(k)s: Contributions to traditional IRAs and 401(k)s reduce your taxable income. However, withdrawals are taxed at ordinary income rates. Required minimum distributions (RMDs) start at age 73. Withdrawals before age 59 ½ are subject to a tax penalty.

Roth IRAs and Roth 401(k)s: Contributions to Roth accounts are not tax-deductible. However, withdrawals after five years following the first contribution are tax-free for Roth IRAs, including gains. Withdrawals before age 59 ½ are subject to a tax penalty.

Life Insurance Proceeds: Life insurance proceeds are generally not subject to tax when received as a beneficiary. However, surrendering a policy for cash may have tax implications.

Savings Bonds: Bond interest is generally taxable at ordinary income rates upon maturity or redemption but may be tax-free for education expenses if certain conditions are met.

Annuities: For annuities, the portion representing the principal is tax-free; earnings are taxed at ordinary income rates unless purchased with pre-tax funds.

Home Sales: Under the Section 121 home sale exclusion, primary home sale gains up to $250,000 ($500,000 for married couples) are excluded from income tax if specific ownership and use criteria are met.

Which states do not tax retirement income?

Crafting a tax-efficient retirement strategy requires careful consideration of various income sources and their tax implications. 

• Seek professional guidance if you need help making decisions that maximize your retirement funds and minimize tax burdens.

Also, note that while this article focuses on federal taxes on different types of retirement income, it is essential to consider the impact of state and local taxes on your finances. (There are more than a dozen states that don’t tax retirement income.) 

Source: https://www.kiplinger.com/taxes/how-retirement-income-is-taxed

Here’s how to handle an inheritance like a pro. A bequest could change your life, but don’t quit your day job.

BY SANDRA BLOCK

LAST UPDATED 23 MAY 2024

CONTRIBUTIONS FROM

ERIN BENDIG

We’ve all heard stories about individuals who passed away quietly after a life of frugality, leaving a fortune to their unsuspecting heirs or, occasionally, a beloved pet.

The reality is a lot less riveting. According to the Washington Post, the average American has inherited only about $58,000 as of 2022, taking into account that most of us won’t receive any form of inheritance. The Federal Reserve also reports that from 1989 to 2007, on average, only 21%  of American households at a given point in time received a wealth transfer.

Complicating matters is the fact that many estate plans contain a smorgasbord of items, including real estate, investments, cash, retirement savings accounts and life insurance plans. It could take months to track down these assets and divide them among the estate’s heirs, and you could incur significant legal fees — particularly if the estate was large or your relative died without a will. There are also different rules for different heirs: Spouses, for example, enjoy some tax breaks and exemptions that aren’t available for adult children or other heirs.

For example, Brian Lee of Tacoma, Wash., got a crash course in estate law after his late father’s brother and sister died almost within a year of each other, in late 2015 and 2017. Neither of his father’s siblings had children when they died, so their estates were divided among their nieces, nephews and other surviving relatives. 

Lee ended up with a six-figure inheritance, but because his uncle died without a will, settling the estate took months and cost thousands of dollars in legal fees. Lee’s aunt had a will, with Lee as the executor, which made “all the difference in the world in terms of the process,” Lee says.

Here’s what you need to know in order to handle an inheritance like a pro.

What you’ll owe in taxes

Stocks: Unless your parents were fabulously wealthy, you won’t have to worry about federal estate taxes, but that doesn’t mean Uncle Sam has no interest in your inheritance. If you inherited stocks, mutual funds or other investments in a taxable account, you’ll be able to take advantage of a generous tax break known as a step-up in basis. The cost basis for taxable assets, such as stocks and mutual funds, is “stepped up” to the investment’s value on the day of the original owner’s death. 

For example, if your father paid $50 for a share of stock and it was worth $250 on the day he died, your basis would be $250. If you sell the stock immediately, you won’t owe any taxes; if you hold on to it, you’ll only owe taxes (or be eligible to claim a loss) on the difference between $250 and the sale price.

It’s a good idea to notify the investment account custodian of the date of death to ensure that you get the step-up, said Annette Clearwaters, a certified financial planner in Mount Kisco, N.Y.

Because of this favorable tax treatment, a taxable-account inheritance could be a good source of cash for a short-term goal, such as paying off high-interest debt or making a down payment on a house, said Jayson Owens, a certified financial planner in Anchorage, Alaska. If you’d rather keep the money invested, review your inherited investments to see whether they are appropriate for your portfolio. For example, you could sell individual stocks and invest the money in a diversified mutual fund without triggering a big tax bill.

Retirement accounts: If you inherited a tax-deferred retirement plan, such as a traditional IRA, you’ll have to pay taxes on the money. Spouses can roll the money into their own IRAs and postpone distributions — and taxes — until they’re 73. 

However, The Setting Every Community Up for Retirement Enhancement (SECURE) Act, which took effect on Jan. 1, 2020, changed the inherited IRA rules for non-spouse heirs. Instead of taking required minimum distributions, based on their age and life expectancy, heirs must withdraw all assets from the inherited IRA or 401(k) within 10 years of the death of the owner. 

If you were fortunate enough to inherit a Roth IRA, you’ll still be required to deplete the account in 10 years, but the withdrawals will be tax-free. If you inherit a traditional IRA or 401(k), you may want to consult with a financial planner or tax professional to determine the best time within the 10-year window to take taxable withdrawals. For example, if you’re close to retirement, it may make sense to postpone withdrawals until after you stop working, since your overall taxable income will probably decline.

Real estate: When you inherit a relative’s home (or other real estate), the value of the property will also be stepped up to its value on the date of the owner’s death. That can result in a large lump sum if the home is in a part of the country that has seen real estate prices skyrocket. Selling a home, however, is considerably more complex than unloading stocks. You’ll need to maintain the home, along with paying the mortgage, taxes, insurance and utilities, until it’s sold.

Life insurance: Proceeds from a life insurance policy aren’t taxable as income. However, the money may be included in your estate for purposes of determining whether you must pay federal or state estate taxes.

Spending your windfall

Even a small inheritance can represent more money than you’ve ever received at one time. Go ahead and treat yourself to a modest splurge — a special vacation, for example — but avoid making costly changes in your lifestyle.

Brian Lee used his inheritance to pay off his wife’s student loans and a small credit card debt; the rest went into retirement savings. Lee says he wanted to honor the legacy of his uncle, a dedicated investor who worked for IBM in the custodial department for 30 years. Lee’s uncle spent most of his life in the same small house in Austin, Texas, and drove a 1967 Ford truck, but he was a wealthy man, with an estate valued at more than $3 million when he died. “There’s no way I would blow money someone spent a lifetime saving,” Lee says.

However, many people overestimate how long their newfound wealth will last. For this reason, consider stashing your inheritance in a money market account or CD account for six months to a year. You’ll earn interest on your cash, and your money will be safe while you assemble a team of professionals, which typically should include a fee-only planner, a tax professional and an attorney.

Your team can help you look for ways to fortify your finances. Paying off credit cards and student loans will relieve you of high-interest debt and free up cash for other purposes. If you haven’t saved enough to cover several months’ worth of expenses, use your windfall to beef up your emergency fund. 

Once you’ve got that covered, consider using your inheritance to increase retirement savings. Finally, if you don’t have an estate plan of your own, use some of the money to create one, including powers of attorney, health care directives, a will and, if necessary, a living trust. Your own heirs will thank you.

Source: https://www.kiplinger.com/article/investing/t064-c000-s002-smart-ways-to-handle-an-inheritance.html

If you’re in your highest-earning years, you can make up for lost time.

BY SANDRA BLOCK

PUBLISHED 1 JUNE 2024

You’ve no doubt heard from multiple sources (including Kiplinger) that the key to retirement security is to save early and often. Thanks to the value of compound interest, even small contributions to a 401(k) or other retirement savings plan when you’re starting out will add up significantly over time.

However, there’s math and then there’s reality. Young workers have multiple demands on their finances, from student loan payments to the rising cost of child care. It’s not unusual for individuals in their twenties and thirties to put their savings on hold, or limit the amount of their contributions, until those obligations begin to diminish and they reach their highest-earning years.

But just as it’s never too late to start strength training, it’s never too late to save for retirement. Here are some strategies you can use to turbocharge your savings. 

Catch-up contributions

The easiest way to ramp up your retirement savings is to make catch-up contributions to your 401(k) or other employer-provided plan. In 2024, if you’re 50 or older, you can contribute an extra $7,500 in addition to the $23,000 maximum 401(k) contribution, for a total of $30,500. If you have a traditional IRA or Roth IRA, you can contribute an additional $1,000 beyond the standard $7,000 limit for those younger than 50, for a total contribution of $8,000 in 2024.

If your employer-provided plan offers a Roth 401(k) — and most large plans do — consider dedicating at least a portion of your catch-up contributions to that account, especially if you already have a large balance in a tax-deferred plan. Although contributions to a Roth 401(k) are after-tax, withdrawals are tax-free as long as you’re 59½ or older and have owned the account for at least five years. And you can contribute to a Roth 401(k) regardless of your income level. 

By contrast, to be eligible to contribute the maximum amount to a Roth IRA in 2024, your modified adjusted gross income (adjusted gross income with certain deductions added back) must be less than $146,000 if you’re single or less than $230,000 if you’re married and file jointly. Contributions begin phasing out above those amounts, and you can’t put any money into a Roth IRA once your income reaches $161,000 if you’re single or $240,000 if you’re married and filing jointly.

In the past, you had to take required minimum distributions from Roth 401(k) plans when you reached the age that triggers RMDs for traditional IRAs and 401(k)s (currently 73). But the law known as SECURE Act 2.0, a broad package of changes to rules governing retirement and retirement savings plans, eliminated that requirement, effective this year. 

Starting in 2026, some workers who want to make 401(k) contributions may have to put some of them in a Roth 401(k), whether they like it or not. A provision in SECURE Act 2.0 will require workers age 50 or older who earned $145,000 or more in the previous year to funnel catch-up contributions to Roth 401(k) plans. The change was originally scheduled to take effect this year, but the IRS postponed implementation of the rule after plan providers and employers — particularly those who don’t yet offer a Roth 401(k) — said they needed more time to prepare. 

After-tax contributions

If you’ve maxed out on catch-up contributions (or you aren’t yet old enough to make them), you may want to consider making after-tax contributions to your 401(k), assuming your employer allows them. In 2024, you can save up to $69,000 in combined employee and employer contributions, or $76,500 if you’re 50 or older. 

Like contributions to a Roth 401(k) (or Roth IRA), contributions are after-tax, but earnings are only tax-deferred; you’ll pay taxes on them at ordinary income tax rates when you take withdrawals. Given that, you may be wondering why you’d use this strategy instead of simply investing extra savings in a taxable brokerage account (which we’ll discuss later).

Here’s why: With a strategy that has been dubbed the “mega backdoor Roth IRA,” you may be able to convert those after-tax contributions to a Roth IRA or, if your plan offers one, a Roth 401(k). Once the money is in a Roth, earnings will grow tax-free, and withdrawals will be tax-free as long as you’re 59½ and have owned the Roth for at least five years. And you won’t be required to take RMDs from the account. “That’s the promised land,” says Ed Slott, founder of IRAhelp.com. “It’s way better off than a brokerage account.”

Now for the caveats, and there are quite a few. First, your plan must allow both after-tax contributions and what’s known as in-service distributions, which allow employees to withdraw funds from their plans while they’re still working. While the IRS permits after-tax contributions and in-service distributions, plans aren’t required to provide them. Only about one-fourth of companies allow after-tax contributions, although it’s more common among large employers. 

An even bigger hurdle is the IRS nondiscrimination rule, which limits the amount some high earners can contribute to their 401(k) plans. The IRS requires 401(k) plans to pass certain tests to ensure that the plan doesn’t favor highly compensated employees over lower-paid workers. Plans are subject to two anti-discrimination tests, one that measures pretax and Roth contributions by both types of employees, and a second that measures employer matches, profit-sharing and after-tax contributions. Because highly paid employees are typically the only workers who can afford to make after-tax contributions, it’s difficult for many companies — especially small and medium-size businesses — to pass the second test, says Ian Berger, an IRA analyst with IRAhelp.com. 

These restrictions don’t apply to solo 401(k) plans, which are primarily used by self-employed business owners, Berger notes. Participation in a solo 401(k) plan is limited to the business owner (and in some instances, his or her spouse), so the anti-discrimination rules don’t apply. If your plan allows it — and not all solo 401(k) plans do — you can make after-tax contributions up to the maximum allowed and do an in-plan Roth conversion or roll over the funds into a Roth IRA. 

The mega backdoor Roth has been in the political crosshairs since news reports revealed that PayPal cofounder Peter Thiel used the strategy to shield billions of dollars in shares of a pre–initial public offering from taxes, potentially forever. Lawmakers have proposed prohibiting individuals from converting after-tax contributions to a Roth, but none of the initiatives have been enacted into law. 

Because the mega backdoor Roth is complex — and not for everyone — consider consulting with a certified financial planner who has experience working with high-income investors to determine whether this strategy is right for you. 

Brokerage accounts

Taxable brokerage accounts are sometimes overlooked as retirement savings tools because they’re, well, taxable. But there are solid arguments for adding a brokerage account to your retirement toolkit, particularly if you’ve taken advantage of all of the available tax-advantaged accounts. 

Funds invested in a taxable account are unencumbered by early-withdrawal penalties, making them a good option for someone who wants to retire early (although if you’re behind on retirement saving, that may not be realistic). You don’t have to take distributions after you reach a specific age as you do with traditional IRAs. And unlike tax-advantaged accounts, taxable brokerage accounts don’t come with annual limits on the amount you can invest. 

Although gains on your investments are taxable, you can take steps to minimize the tax bill. As long as you hold investments in your taxable account for more than a year, gains will qualify for a long-term capital gains rate that’s likely lower than your income tax rate — the rate that applies to short-term gains for investments held in your account for one year or less. Most taxpayers pay 15% on long-term capital gains, and if your taxable income is low enough — in 2024, $47,025 or less if you’re single or $94,050 or less if you’re married and file jointly—you qualify for a 0% rate on long-term capital gains. (Single filers with taxable income of more than $518,900 and joint filers with income of more than $583,750 are subject to the maximum 20% rate; those with income that falls between the 0% and 20% thresholds pay the 15% rate.)

When determining how to invest funds in a mix of taxable and tax-advantaged accounts, you can lower your overall tax bill by using a strategy known as asset location. Exchange-traded funds are good choices for your taxable accounts, because many are index funds, which tend to generate less in capital gains distributions compared with actively managed mutual funds. Even active ETFs tend to be more tax-efficient than mutual funds because of the way they are structured.

Because interest payments from municipal bonds and municipal bond funds are often exempt from federal taxes — and in some cases from state and local levies — munis are also good choices for your taxable account. 

Meanwhile, other bonds and bond funds are better candidates for your tax-deferred accounts because interest is taxed at your ordinary income tax rate, which could be as high as 37% if you’re earning a high income. Sheltering interest-generating investments in your tax-deferred accounts will enable you to postpone paying taxes on that money until you retire and start taking withdrawals. 

Actively traded mutual funds that throw off a lot of taxable capital gains distributions are also better suited for your tax-advantaged accounts. Funds that offer the potential for a high rate of return, such as those that invest in small- and mid-capitalization stocks, are good candidates for your Roth accounts because you’ll be able to take advantage of long-term, tax-free growth. 

If your goal is to leave a legacy, a taxable account could provide an important component of your estate plan. On the day you die, your investments will receive what’s known as a step-up in basis, which means the cost basis of the investments — the amount you paid for them — will be adjusted to their current market value. If your heirs turn around and sell the investments, they’ll owe little or no tax on those appreciated assets. 

Health savings accounts

Health savings accounts are primarily viewed as a way to cover your unreimbursed medical expenses, but they also provide a tax-advantaged way to save for health costs in retirement. 

Contributions to an HSA are pretax (or tax-deductible if your HSA is not provided through your employer), funds grow tax-free, and withdrawals are tax-free as long as the money is used for eligible health care expenses. If you have an individual health insurance plan, you’ll be allowed to contribute up to $4,150 in 2024. For family coverage, you can contribute up to $8,300. If you’ll be 55 or older at the end of the year, you can put in an extra $1,000 in catch-up contributions.

To qualify for an HSA, your health plan must have a deductible of at least $1,600 for individual coverage or $3,200 for a family plan. The plan must limit out-of-pocket expenses to $8,050 for self-only coverage or $16,100 for family coverage. 

If you have enough disposable income to pay for your current health care expenses out of pocket and avoid taking withdrawals from your HSA, you can get the most out of your HSA’s triple tax advantage, says Nilay Gandhi, a certified financial planner and senior wealth adviser with Vanguard Group. As long as you invest at least a portion of your HSA funds in the stock market — an option that most large plans offer — the money will grow tax-free, and withdrawals will be tax-free as long as the money is used for qualified expenses.

You can use HSA funds to pay for medical costs that Medicare doesn’t cover, as well as monthly premiums for Medicare Part B and Part D and Medicare Advantage plans. You can also use distributions to pay a portion of long-term-care insurance premiums; the amount you can withdraw tax-free depends on your age. 

Once you turn 65, you can take penalty-free withdrawals for non-medical purposes, although you’ll pay taxes on the money (non-medical withdrawals before age 65 are subject to taxes and a 20% penalty). Unlike IRAs, though, there are no required minimum distributions for HSAs, so you can allow the funds to grow throughout retirement.

Source: https://www.kiplinger.com/retirement/ways-to-catch-up-on-retirement-savings