One of the key advantages of retirement plans like 401k accounts, Thrift Savings Plan for federal government employees or traditional Individual Retirement Accounts (IRA) is the ability to shelter income from taxes while working. Contributions to these accounts are not taxed until the funds are withdrawn in retirement when many retirees are in a lower tax bracket.
Withdrawals from these accounts after age 59.5 are taxed as ordinary income. Any withdrawals before age 59.5 will incur a 10% penalty as well as income taxes. (Although there are a few situations when retirees can access these funds before age 59.5). The sections below explain how federal taxes apply to withdrawals and how a retiree can use the standard deduction to reduce their tax obligations. There is also an explanation of blending non-taxable Roth 401ks and Roth IRAs with taxable 401ks or traditional IRAs to reduce taxes.
2022 Federal Tax Rates
Under federal taxes the marginal tax rates increase as income levels rise. But only the dollars earned in the next tax bracket are taxed at the next higher rate. For example, a single filer earning $41,776 would only pay a marginal tax rate of 22% on their last $1 earned. The first $10,275 is taxed at 10% and the earnings from $10,276 to $41,775 are taxed at 12%. But as we will see below using the standard deduction in retirement helps reduce these taxes.
Tax Rate______Single Filer _Married Filing Jointly
10% Up to $10,275 Up to $20,550
12% $10,276 to $41,775 $20,551 to $83,550
22% $41,776 to $89,075 $83,551 to $178,150
24% $89,076 to $170,050 $178,151 to $340,100
32% $170,051 to $215,950 $340,101 to $431,900
35% $215,951 to $539,900 $431,901 to $647,850
37% $539,901 or more $647,851 or more
Standard Deduction Still Applies to Retirement Funds
Retired taxpayers can claim the standard deduction to lower their tax liability just like working taxpayers. For the 2022 tax year the standard deduction is $12,950 for singles and $25,900 for married couples filing jointly. If a retiree is age 65 or older they are allowed to add another $1,400 to their standard deduction. This is a nice additional tax benefit for senior citizens.
Example: Tax on $60,000 Withdrawal in Retirement
Below is the tax obligations for a married couple aged 60 who are filing jointly. They have withdrawn $60,000 from their tax deferred retirement account. If this was their only source of income for the year their federal tax is shown below:
Withdrawal Amount $60,000 Federal tax
$25,900 (standard deduction) $0
$20,550 taxed at 10% $2,055
$13,550 taxed at 12% $1,626
Total federal tax $3,681
The total tax on the $60,000 withdrawal is $3,681 which equates to an effective tax rate of 6.1%. This rate is found by dividing the total tax by the distribution ($3,681/$60,000). They were able to shelter some of their earnings during their career that would have been subjected to a higher marginal tax rate. Now as retirees they withdraw these funds while in a lower marginal tax rate.
State Income Tax
A similar process applies to states with an income tax. States tend to offer a standard deduction and then apply tax at either a flat rate or a marginal rate. When looking to lower expenses in retirement it is worth noting that there seven states without an income tax. These include Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. Also New Hampshire and Tennessee do not tax earned income, so tax deferred withdrawals are not taxed. Three more states, Illinois, Mississippi and Pennsylvania, have a state income tax, but do not tax withdrawals from tax deferred retirement accounts.
Keep in mind that a state without an income tax may still tax in other ways. Some of these states have higher sales tax or property tax, to generate revenue. In other cases the state spends less on certain public services. Due diligence is required when looking at the tax benefits of one state versus another.
No FICA Tax on Retirement Withdrawals
While working earnings are subject to income tax and also Federal Insurance Contributions Act (FICA) tax of 7.65%. This consists of 6.2% for Social Security and 1.45% for Medicare to provide these programs for senior citizens. FICA tax applies to 401k contributions when they were initially made, so FICA tax is not paid on withdrawals. This enables retirees to keep more of their money withdrawn from retirement accounts.
Roth 401k and Roth IRA Withdrawals
There are also retirement accounts that are funded with after tax contributions, these include Roth 401k or Roth IRA accounts. Retirees who have these accounts will not pay any federal tax on withdrawals. One strategy is to blend withdrawals between a regular 401k and a Roth account to keep the total taxable amount lower each year.
For example, our retirees above could have withdrawn $50,000 from a 401k and $10,000 from a Roth IRA. Doing so would have reduced their tax obligations by $1,200 and lowered their effective tax rate from 6.1% to 4.1% ($2,481/$60,000). The tax paid is shown below:
Withdrawal Amount $60,000 Federal Tax
$10,000 Roth distribution Not taxed
$25,900 (standard deduction) $0
$20,550 taxed at 10% $2,055
$3,550 taxed at 12% $426
Total federal tax $2,481
Tax Rates Can Change
Keep in mind that tax rates and the standard deduction can change in the future. The current tax brackets used in the example above are set to expire after 2025, reverting back to pre-2018 brackets, unless Congress extends the current rates. It is wise to include higher tax rates in retirement planning to prevent unpleasant surprises.
For more information see the article explaining the five benefits of a 401k plan and the difference between a 401k and Roth 401k. There is also an article about strengthening your withdrawal plan in retirement. For more detailed information on taxes in retirement and creating a plan for financial independence see Become Loaded for Life and the 10 Stages Workbook.
