Capital Gains vs. Ordinary Income: What Retirees Should Know About Investment Taxes

When you imagine retirement, it might include traveling to exotic destinations, spending more time with family or diving deeper into a favorite hobby. Whatever your vision, achieving it requires a shift in mindset – from building wealth to generating a reliable income stream.

One critical element of this transition is understanding how taxes impact your retirement income. Unlike your working years, when your employer withheld and prepaid your taxes, retirement often means managing your own tax bill. For many, this can feel overwhelming.

In fact, one survey revealed that 70% of households nearing or in retirement need advice on income planning and tax strategies.

To help you keep more of your hard-earned money, let’s break down how different types of income are taxed in retirement – and how you can plan smarter to reduce your tax burden.

Ordinary Income: The Basics

Ordinary income includes wages, withdrawals from tax-deferred accounts like traditional IRAs or 401(k)s, and interest from savings accounts. This income is taxed at your marginal income tax rate, which can vary based on how much total income you earn in a year.

For retirees, withdrawals from tax-deferred accounts are one of the most common sources of taxable income. While contributing to these accounts during your working years offers a tax break upfront, withdrawals in retirement are taxed as ordinary income, potentially pushing you into a higher tax bracket.

Capital Gains: A Different Tax Treatment

Capital gains occur when you sell an investment, such as stocks, bonds or real estate, for more than you paid for it.

Unlike ordinary income, capital gains are taxed at preferential rates:

• Short-term capital gains (on investments held for less than a year) are taxed as ordinary income.
• Long-term capital gains (on investments held for more than a year) are taxed at lower rates – 0%, 15% or 20%, depending on your income.

For retirees, planning when and how to sell investments can significantly impact your overall tax bill. Selling appreciated assets during a year with lower income, such as early retirement, can help you take advantage of lower long-term capital gains rates.

Other Tax “Gotchas” to Watch For

Taxes in retirement don’t stop at ordinary income and capital gains. There are additional factors that can catch retirees off guard:

1. Social Security Taxes
   If your combined income (adjusted gross income + non-taxable interest + half of your Social Security benefits) exceeds certain thresholds, up to 85% of your benefits may be taxable. Additionally, some states tax Social Security benefits, so it’s essential to know your state’s rules.
2. Medicare Surtax
   Retirees with higher incomes – above $250,000 for married couples or $200,000 for single filers – may face a 3.8% Medicare surtax on net investment income, including dividends, interest and capital gains.
3. Required Minimum Distributions (RMDs)
   Once you turn 73 (or 75 starting in 2033), you must begin taking RMDs from traditional IRAs and 401(k)s. These distributions are taxed as ordinary income and can create a hefty tax bill if not planned for in advance.

The Role of Asset Location in Tax Planning

Placing the right types of investments in the right accounts can help you optimize tax efficiency. In addition to diversifying your portfolio, it can be beneficial to diversify your accounts for greater flexibility in managing taxes throughout retirement.

Here’s how to think about the three main types of accounts:

• Taxable Accounts
  These include brokerage accounts where dividends, interest and realized capital gains are taxed annually. Taxable accounts are ideal for investments that generate qualified dividends or long-term capital gains, as these are taxed at lower rates.
• Tax-Deferred Accounts
  Examples include traditional IRAs, 401(k)s and 403(b)s. These accounts allow for tax-deferred growth, making them a good place for investments that generate significant income where taxes are postponed until withdrawal.
• Tax-Free Accounts
  Roth IRAs and health savings accounts (HSAs) fall into this category. Since withdrawals are tax-free, these accounts can be reserved for high-growth investments you plan to access later in retirement, especially to offset higher tax rates or unexpected expenses.

Generally, it makes sense to draw from taxable accounts first, followed by tax-deferred accounts, and finally, tax-free accounts like Roth IRAs. This approach preserves the tax-free growth potential of Roth accounts for later years.

However, deciding which investments go in which accounts – and when to withdraw funds – depends on your unique financial situation. Working with a financial adviser can help you develop a personalized tax strategy that aligns with your goals.

Strategies to Reduce Your Tax Burden

Smart tax planning can help you keep more of your retirement savings. Here are some common strategies to consider

1. Roth Conversions
   Converting funds from a traditional IRA to a Roth IRA can spread your tax liability over several years, allowing for tax-free withdrawals later. Especially, if you expect your tax rate to rise in the future.
2. Prepare for RMDs
   Required Minimum Distributions (RMDs) can significantly impact your tax bill. Planning ahead with the help of a financial adviser can minimize the tax bite and align withdrawals with your financial goals.
3. Offset Taxes with Charitable Giving
   Strategies like using a donor-advised fund or making a Qualified Charitable Distribution (QCD) directly from your IRA can reduce taxable income while supporting causes you care about.

The Bottom Line

Understanding how different types of income are taxed in retirement can help you preserve more of your “retirement paycheck.” By planning ahead, diversifying your income sources and timing your withdrawals strategically, you can reduce your tax burden and make your savings last longer.

Retirement is a balancing act, but you don’t have to go it alone. Working with a financial adviser can help ensure your income plan aligns with your financial goals while minimizing taxes.

Ready to start planning? Let’s talk.