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[Video] Taxes in Retirement 101 Thumbnail

[Video] Taxes in Retirement 101

Financial Planning Insights Retirement Tax Planning YouTube

Understanding how taxes relate to you in retirement is crucial for effective financial planning. By considering the tax implications of different income sources, implementing tax planning strategies, and staying informed about federal and state tax laws, you can make informed decisions that maximize your retirement income and minimize your tax burden.

U.S. Tax Code

Today, we're going to start with a real high-level view, Taxes 101 is what I call it. Basically, what we have in our country is seven different brackets or seven buckets for regular income tax. I might interchange those two, I might say, buckets or brackets, but I mean the same thing.

Then we have three buckets of capital gains and preferred dividends, which are preferred rates and are a little bit lower than ordinary income. And then we have deductions and credits. We're going to talk a little bit about each one of those today.

Alright, so first, as I mentioned in a previous video on the history, our tax code, originally in 1913, when we first implemented the tax on income, had seven brackets, same as today. Back then, those brackets ranged from one to seven percent. Today, those brackets are 10, 12, 22, 24, 32, 35, and 37. So quite a bit different, right? And right now, those are basically the highest rates in our current tax code.

The rise and run of each bracket is different too. So intuitively, a lot of times people think maybe all the brackets are similar in size, but that's not true. And obviously, the jump between 10 and 12 percent is a lot different than the jump between 12 and 22 percent.

If you want to think of it like maybe you had a carpenter build stairs for a back deck or something. Well, if your stairs looked like the rise and run of our tax bracket, then you would definitely fire that carpenter because they're not even close to being the same. But right now, that is how our bracket system works.

Then also we have what is known as a marginal tax rate, which basically means that only that last dollar was taxed at whatever rate you're in. So that's why sometimes your effective or your average rate is quite a bit different than your tax bracket.

Let's say hypothetically, you're in the 22% bracket, but your average or your effective tax rate might only be 14 or 15%. The reason for that is after your deductions, each bracket is only taxed in that bracket. So, the income in the 10% bracket is charged 10%, the income in the 12% bracket is charged 12%, and then whatever bumps into the 22% bracket will be taxed at that rate.

If you had $1,000 bumped into that 22% bracket, you would pay 22% just on that $1,000. So that's what marginal means.

Capital Gains

Okay now on to capital gains and qualified dividends. They get a little bit different treatment because this code is basically meant to incentivize investments. They want to encourage investments in the economy.

They want to try to help people help themselves as far as it pertains to saving for retirement and using their money to work for themselves. So they gave us quite a bit better treatment for capital gains and qualified dividends.

For capital gains, we have a 3-bucket system as opposed to our seven regular income tax brackets. First, we have 0% all the way up to about $89,000 or $90,000. And that's about the same as kicking into the 22% bracket as ordinary income.

So basically we have zero percent on the capital gains all the way up to the 10 and the 12% brackets of regular or ordinary income. And then the next bracket of the capital gains and ordinary dividends is 15%. And it kicks in about the same time as the 22% bracket on the ordinary income side. So it's quite a bit less than that, and that bracket goes all the way up to about $550,000.

All these amounts I'm talking about when I talk about thresholds, I'm talking about married filing jointly, but if you're an individual, just basically cut the thresholds in half. That's how our brackets are basically set up right now.

But our capital gains go all the way up to a little more than $550,000 that we only pay 15%. Then they cap out at 20%. So if you're over that, you're only paying 20%. So that’s a pretty big difference considering our ordinary income rates top out at 37%.

So these are definitely preferred brackets. In order to get these rates, basically you have to have dividends that are domestic. Then in order to get to the long-term capital gains you have to have an investment held for at least a year.

And then the rise and run of these brackets is very big. As I said, nothing even kicks in until about $90,000. You're in the zero percent rate for the capital gains, and then the 15% capital gains rate goes all the way up to about $550,000. So a very, very big step, if you will.

Deductions, Exemptions, and Credits

Then there are credits. Dollar for dollar, a credit is better than a deduction because a credit is actually going to reduce your tax bill by that amount. Deductions are just going to reduce the amount that actually gets taxed, so dollar for dollar, credits are better. 

They put credits into the tax code to basically incentivize behavior. They have a health care tax credit because they want people to make sure that they've got health care. 

We want to be making sure that we're taking advantage of all these things during our gap years, which are the years between retirement and when required minimum distributions (RMDs) are required.

Other videos in this series:

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Disclaimer: Since we don’t know your specific situation, none of this information should be construed as tax, legal, financial, insurance, or other advice and may be outdated or inaccurate. It is your responsibility to verify all information yourself. This content is prepared for educational and informational purposes only, and you should seek professional help for your specific situation. Eagle Ridge Wealth Advisors  or its members cannot be held liable for any use or misuse of this content.