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Michigan Income Tax Rules for IRA Distributions

Michigan Income Tax Rules for IRA Distributions

April 11, 2024

Michigan Income Tax Rules for IRA Distributions

Let’s run a simple test. Think of the feeling you get when you hear these words:

Christmas

Fresh cookies 

Hugging a close friend or family member

Taxes

Your favorite song


๐„ž One of these things is not like the other๐„ž

 

Did hearing the word “taxes” make you clench your fists, grit your teeth, and your blood pressure increase? Don’t worry, this is a completely normal response. I am not here to give you a speech on why taxes should make you feel warm and fuzzy (trust me, this is not my favorite topic to write on). I talk about it because it is tax season and this is a topic that can save you a large amount of money. As a southern Michigan company, I will focus on Michigan taxpayers and how we can minimize taxes on income from retirement accounts. 

Brief Lesson on Taxes

To understand how to save on your taxes, we need to first understand how they work. It should be said that I am not a tax expert so any specific questions should be directed towards tax professionals. With that being said, being a financial advisor requires a thorough understanding of how to minimize your tax burden on investment accounts. Income taxes are taxes on any income you make during a calendar year. The amount of tax you pay is based on several factors including these:

Filing Status

Your filing status is in essence whether you are married or have dependents. If you have neither of those, you are a single filer and fall into this bucket. If you are married you can decide whether to file married filing jointly (joint return or joint filers) or married filing separately. If you are unmarried but have dependents you can file as a head of household.

Tax Brackets

Here are the tax rates from 2023:

Tax rate

Single filers

Married filing jointly

Married filing separately

Head of household

10%

$0 to $11,000

$0 to $22,000

$0 to $11,000

$0 to $15,700

12%

$11,001 to $44,725

$22,001 to $89,450

$11,001 to $44,725

$15,701 to $59,850

22%

$44,726 to $95,375

$89,451 to $190,750

$44,726 to $95,375

$59,851 to $95,350

24%

$95,376 to $182,100

$190,751 to $364,200

$95,376 to $182,100

$95,351 to $182,100

32%

$182,101 to $231,250

$364,201 to $462,500

$182,101 to $231,250

$182,101 to $231,250

35%

$231,251 to $578,125

$462,501 to $693,750

$231,251 to $346,875

$231,251 to $578,100

37%

$578,126 or more

$693,751 or more

$346,876 or more

$578,101 or more


US Federal Taxes are based on a tiered system known as tax brackets. You take your filing status (previous chart) and then calculate your federal income tax based on how much gross income you have (this is simplified for the sake of explanation but remember any tax deduction will bring down your gross income). Remember that this is a tiered system so if you are a single filer who made $100,000 in 2023, your income is not taxed entirely at the 24% tax rate. Your first $11,000 in income is taxed at 10%, anything between $11,001 - $44,725 is taxed at 12%, and the remaining amount is taxed at 22%. The example breaks down like this:

Bracket

Amount of Income Taxed

Tax Amount

10%

 $11,000

 $1,100

12%

 $33,725

 $4,047

22%

 $50,650

 $11,143

24%

 $4,625

 $1,110

 Total

 $100,000

 $17,400

17.4%

Your total amount taxed ends up being $17,400 or a 17.4% effective (average) tax. 

Differences in Roth and Traditional IRA Taxes

Just as there are many different types of jobs, there are also different types of retirement contribution plans. 401(k), 403(b), 457, and Traditional IRA just to name a few. Many of these accounts also have a Roth option. The main difference between the tax treatment of Roth and Traditional IRAs lies in when you pay taxes, either on contributions or withdrawals. Keep in mind that you need to wait until you are 59 1/2 to withdraw from Traditional IRAs to avoid a 10% penalty on top of paying income tax.

In traditional retirement accounts such as 401(k) and Traditional IRA (non-Roth), you pay income tax on withdrawals in retirement. These count as taxable income. Other forms of taxable income in retirement would be pension income, Social Security benefits (depending on your total income and filing status), annuity distributions, investment income for non-retirement accounts, and any income you get from a job.

Contributions to Roth accounts are made with after-tax dollars, so you won't owe any taxes on your withdrawals in retirement. Any money you withdraw from Roth accounts is nontaxable income. Also included as nontaxable income are gifts, life insurance proceeds, child support payments, interest from municipal bonds, and several others. We will be focusing on Roth IRA distributions. As the name implies, you don't have to pay taxes on this time of income. 

Which one is better? It all comes down to whether you expect to be in a higher tax bracket now or in retirement. If you anticipate being in a higher tax bracket when you retire, you should likely invest in Roth accounts. If you anticipate being in a lower tax bracket in retirement than you are now, you are likely better off investing in tax-deferred accounts. I always point out that from a historical perspective, we are in low tax brackets relative to other times in history and adjusted for inflation. Our national debt also continues to increase year after year. These could be signs that our tax brackets will be higher in the future meaning that Roth accounts could help minimize your taxes paid. 

Required Minimum Distributions

A big consideration for Michigan retirees when dealing with retirement tax on qualified plans is required minimum distributions (RMDs). These are when the government forces you to start taking money out of tax-deferred accounts when you reach age 72 (73 if you reach age 72 after Dec. 31, 2022). The amount you have to pull out is a percentage of the total amount you have saved in these accounts and goes up each year you get older. A good way to avoid RMDs if you already have money in tax-deferred accounts is by doing Roth conversions. 

Special Michigan-Only Considerations

Michigan residents should also be aware of the state income tax rates when considering their retirement savings options. Michigan state taxes have a flat income tax rate of 4.25%, which applies to all taxable income. This means that regardless of your income level, you will pay the same percentage in state income taxes. This means that you will be taxed the same on your IRA distributions regardless of when you use them (barring any changes to this tax rate in the future).

Additionally, Michigan does not tax Social Security benefits or retirement account withdrawals, such as those from a Traditional IRA or 401(k). This can be a significant advantage for retirees, as it allows them to keep more of their retirement income without having to worry about state taxes eating into their savings.

Retirement Savings Contributions Credit (Saver’s Credit)

If you are 18 or older, not a student, and are not claimed as a dependent on another person’s tax return, you may be eligible for a lesser-known tax credit on contributions to your IRA or employer-sponsored retirement plan. Remember, a tax credit allows you to reduce the amount you owe the Internal Revenue Service. The Retirement Savings Contributions Credit allows an individual to get back up to 50% of their contributions to their retirement accounts. For example, if you are a single filer who earned less than $21,750 in 2023 and you contributed $2,000 to a Roth IRA, you may be eligible for a 50% credit of $1,000 on your tax return. You can find more specifics for this credit on the IRS website. This is a great way for young earners to not only contribute to a Roth IRA but get their contributions back on their tax returns.

Final Thoughts

As I finish up this article, we are less than a week out from Tax Day but the good news is that it isn’t something you can only affect at the end of the year. You can (and should) understand the effects during the current tax year as well. Regardless of whether your retirement income comes from public pension benefits or your private retirement income, always be aware of the consequences of how you support your retirement. A seasoned financial planner and/or tax professional can assist you with ensuring taxes don't eat away at more of your hard-earned income than they have to.