Taxes on 401(k) and IRA Distributions in Michigan

You have saved and saved throughout your working years and now it is time to start taking some money out. You didn’t think the government was going to let you have all of that money tax-free, did you? A lot of things in retirement compared to working are different, and that includes taxes. Some taxes go up, some go down, and others are completely eliminated. This post addresses how much in taxes you have to pay on IRA and/or 401(k) withdrawals in Michigan.

A quick note:  There is currently a proposal to eliminate the Michigan “pension tax”.  The proposal would eliminate Michigan state taxes on 401(k) withdrawals and pension income. To read more about the proposal read my article, “Analyzing The 2019 Proposal to Eliminate the Michigan Pension Tax“.

Federal Taxes

First, let’s clear this up right away.  Both a 401(k) and an IRA distribution are taxed exactly the same.  It doesn’t matter where the money comes from. However, there is one large difference.  When you withdraw funds from a 401(k), you are typically required to have 20% withheld for federal taxes.  This doesn’t mean that you are taxed at 20%, just this is the amount that is withheld and sent to the government.  If your tax rate is lower than that, you will get a refund when you file your taxes. If your tax rate is higher, you may have to pay some when you file your taxes.  On the other hand, you have more control in how much you have withheld from an IRA. You actually decide how much is withdrawn from an IRA. This is an advantage of an IRA because many times retirees don’t need to have 20% withheld to pay for taxes.  Now on to the actual taxation of IRA and 401(k) withdrawals.

For the most part, if you earn income via work or through a 401(k) distribution, you are taxed the same way. For example, let’s say your only income in retirement is a $50,000 401(k) distribution. On the federal level, you are taxed exactly the same if you had a job and earned $50,000.

Below is the tax table for 2019:

2019 Tax bracket

Source: Tax Foundation

Remember, the tax tables refer to taxable income, not total income. There are deductions that you can take from your income to get your taxable income number. As I wrote about before here, based on the updated tax bill most of us in Michigan will now be using the standard deduction. As a reminder, you are able to deduct the greater of your itemized deduction or the standard deduction. The standard deduction for 2019, is $12,200 if single, and $24,400 if married and filing a joint return. These numbers are subtracted from total income to determine your tax liability.

For example, let’s say that you are married and you are using the standard deduction of $24,400. Your only income is a $50,000 IRA distribution. You would subtract $24,400 from $50,000, which equals $25,600 in taxable income. From the chart above we can see that the first $19,400 is taxed at 10% and the next $6,200 is taxed at 12%. This will give you total taxes of $2,684. In this case, the effective tax rate, which is taxed paid divided by total income, is only 5.4%.

Social Security and a 401(k) withdrawal

The math gets a little trickier if you are collecting social security. At most, 85% of your social security is subject to taxation, and depending on your income, there are cases in which none of your social security is taxed. For more about social security taxation, read this article.

Let’s look at the same example as above, but also the couple is collecting $30,000 in social security. In this case, 85% of the social security benefit would be taxable as well as the $50,000 in 401(k) distributions. 85% of $30,000 is $25,500 plus the $50,000 401(k) distribution means that they have $75,500 in income. From there, subtract $24,000 standard deduction and this couple would have $51,500 in taxable income. To calculate the income taxes, they pay 10% on the first $19,400 and 12% on the next $32,100. Total taxes are $5,792 and the effective tax rate would be 6.8%.

You probably aren’t surprised that the more than you earn, or withdraw from your retirement accounts, the more you pay in taxes.  

Social Security and Medicare Taxes

Remember how I told you that if you work or draw money from your 401(k), the taxation is the same?  Well, that is true on a federal level, but you have a huge benefit as a retiree that you don’t have while you are working. You don’t pay any social security or Medicare (FICA) taxes on your income. While you are working, you pay 7.65% on your income to Mr. FICA. This is a huge tax saving in retirement.

Michigan State Taxes

Unfortunately, there is a good chance that you are on the hook for Michigan state taxes on any retirement distribution. The Michigan state tax rate is a flat 4.25%. Now, if you were born before 1953, not all of your income is subject to state taxes. Below is a chart which shows the amount of your retirement account withdrawals and pension income that is exempt from Michigan state taxes.  

Year you were born Pension and Retirement Withdrawals Tax-Free
Prior to 1946 Single:    $50,509

Married:  $101,019

Between 1946 and 1952 Single:    $20,000

Married:  $40,000

After 1952 All income subject to MI state taxes

Source:  State of Michigan

As you can see, if you were born prior to 1952, some of your IRA and 401(k) distributions are free from Michigan state taxes.  However, if you were born after 1952, you will be paying taxes on all of the pension and retirement accounts.  However, some of the income will be tax-free because of Michigan personal exemptions that apply to everyone.   

2018 Change to Michigan Personal Exemptions

Prior to 2018, Michigan used the same personal exemptions as the federal government.  However, in 2018 the federal government increased the standard deduction and eliminated personal exemptions.  Personal exemptions are subtracted from total income to determine your tax liability.  So, if Michigan didn’t make a change, we in Michigan would be paying more in taxes.  However, Michigan implemented their own personal exemptions in 2018.  In 2018, the personal exemption is $4,050 and in 2019 the personal exemption goes up to $4,400 per person here in Michigan.  So, even if you were born after 1952 and all of your pension and retirement withdrawals are subject to Michigan state taxes, you will still be able to subtract your Michigan personal exemptions.  This means that in 2019, a couple can receive $8,800 of income and pay no Michigan state taxes.

Summary

The higher standard deductions and lower tax rates under the new Trump Tax Plan are very beneficial for many retirees.  Combine that with a fairly favorable Michigan state tax rate of 4.25%, and of course, no FICA taxes, and taxes in retirement aren’t too bad.  As the saying goes, the only certainties are death and taxes. Thankfully, taxes may not be too painful for you, at least here in Michigan.

Disclaimer:  I’m a financial advisor, but probably not your advisor and don’t know your complete financial picture.  Therefore, please use this as education only and I strongly suggest talking with your financial advisor or tax preparer before implementing any of the above strategies.

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