Taxes in Retirement. Tax Rules That Await You in Your “Golden” Years.

Retirees face new tax issues when they stop working (or start working part-time). And it affects you whether or not you change tax brackets.

Once retired, many of us will have somewhat lower income than in prime working years. And that implies lower taxes, but most also will have multiple sources of income. And that complicates tax payment for those who are used to a single source of income. There will be Social Security income, minimum required distribution income from tax-advantaged retirement accounts and perhaps other income from investments, property, freelance or part-time work, etc.

So, instead of getting a single paycheck with various withholdings done by an employer and quarterly tax payments transmitted to the IRS by an employer, many retirees will be required to make quarterly payments themselves.

Because your sources of income will probably be more diverse than when you were working, and each source of income comes with a distinct set of tax rules, taxes in retirement are likely to be a bit more complicated than when you were working. Although this is unfortunate, knowledge of these nuances and the optimal timing of withdrawals are critical. With a little education and some strategic planning, you can make the best of it and minimize your taxes and your hassles while you enjoy your retirement lifestyle.

Of course, you want to maximize your income while paying the lowest possible amount of taxes on that income. If you’re approaching retirement, say five years out, it behooves you to take a close look at your future income sources and the amount of taxes you will have to pay in retirement. Then you can budget accurately, plan your withdrawal strategy (“decumulation” planning) and start contemplating making regular tax withholding payments. Just that last fact, the prospect of paying quarterly taxes, requires a significant shift in thinking for most of us.

Let’s take a look at the different types of retirement income you may receive and their associated taxes.

Social Security Income

When the Social Security Act was passed by FDR during the Great Depression, Social Security benefits were never intended to be a primary source of retirement income. Today, according to the Social Security Administration, Social Security payments replace, on average, approximately 40% of pre-retirement wages for retirees. Initially, Social Security payments weren’t subject to taxes. That’s no longer the case; only those who rely primarily on Social Security to pay their bills escape taxation. Those whose only source of retirement income is Social Security probably won’t pay any taxes in retirement (because their overall income is low). However, the largesse of the U.S. Government stops there. For high-income recipients, 15% of benefits are tax-free and 85% are taxed. So, if you have other sources of income (and I hope you do), a portion of your Social Security income is likely to be taxed. A formula determines the amount of your Social Security that is taxable.

The amount that is taxable (anywhere from zero to 85%) depends on how much income you have in addition to Social Security. The IRS calls this other income “combined income.” Money from pensions, part-time jobs, 401(k)s, investments, rental income, etc. falls into this bucket. For example, retirees with a high amount of monthly pension income will likely pay taxes on 85% of their Social Security benefits.

The IRS provides a tax worksheet where you plug your combined income into a formula to determine how much of your Social Security benefits will be taxable each year.

A note about Social Security benefits and geography: Where you live during retirement determines how your Social Security benefits will be taxed at the state level. You may live in one of the 28 states (or Washington, DC) that doesn’t tax Social Security income or you may consider moving to one of them – for at least 183 days per year (the “in residence” cutoff) — when the time comes. Keep in mind some states make up for the loss of revenue on income taxes, including those on Social Security benefits, with other taxes, like higher property taxes.

IRA and 401(k) Withdrawals

With the exception of Roth IRA withdrawals, all other income from retirement accounts is taxed in some way. Once you are 70½, you are required to start withdrawing money from your retirement plan accounts each year. This includes ordinary IRAs as well as 401(k) plans, 403(b) plans, and 457 plans. The government requires you to take the Required Minimum Distribution (RMD), so it can (finally) collect taxes on this income. If you do not withdraw the required amount each year, you will be subjected to stiff penalties. For example, the IRS imposes a 50% tax penalty on amounts that are not properly disbursed from your 401(k).

The amount of tax you pay on these accounts depends on the total amount of income and deductions you have and what tax bracket you are in for that year. For example, if you have a year with more deductions than income (such as a year with a lot of medical expenses), then you may not have to pay tax on withdrawals for that year.

Roth IRAs disbursements are not taxed because those contributions are taxed when they are made to the retirement account. The investment income earned inside a Roth is tax-free and at retirement withdrawals are not taxed. To withdraw tax-free, you must wait until you are at least 59½. Roth IRAs do not have required distributions, so you can let the money grow tax-free for your whole life if you want. Then Roth accounts pass tax-free to your beneficiaries. (Roth beneficiaries do have to take required distributions from the Roth because Uncle Sam is not going to let the money grow tax-free forever!)

Pensions

For most, benefits from pensions and annuities (see below) are fully taxed. As with IRAs and 401(k)s, there’s a simple rule of thumb to predict whether you will have to pay taxes in retirement on pension and annuity income. If the money went into the fund – either by you or your employer — before it was taxed, it will be taxed when you withdraw it. Most pensions accounts are funded with pre-tax income, which means the entire amount of your defined annual pension income will be included on your tax return as taxable income each year.

However; in the unusual circumstance that you funded a portion of your own pension account with after-tax dollars, then that portion of your benefit will not be taxed. As a convenience, you have the option of having taxes withheld directly from your pension checks (less painful).

Annuities

Tax rules for annuities purchased with after-tax dollars–those not part of an IRA or another retirement account–are determined by the type of annuity you own:

  • Immediate Annuities—Payments from an immediate annuity include principal as well as interest. Only the interest portion is considered taxable income.
  • Fixed and Variable Differed Annuities—When you place money in a fixed or variable deferred annuity (deferred meaning the income phase is being deferred until later), you do not have to pay taxes on the gain in the annuity until you take withdrawals. Like most retirement vehicles that offer tax deferral, if you take withdrawals prior to age 59½, any gain withdrawn is taxed at your ordinary income tax rate and is subject to a 10% penalty tax. In a non-qualified deferred annuity (one not owned by an IRA, Roth IRA, or other tax-deferred retirement vehicle), gain is considered to be withdrawn first.

If your annuity is owned by an IRA or another retirement account, then the tax rules of those retirement accounts apply to any withdrawals or annuity payments you receive from that annuity.

Other taxable retirement income

Remember that other income accrued during retirement is also taxed. Interest income, dividends and capital gains on investments will be taxed just as they were before you retired. If you plan to sell investments to generate retirement income, each sale will generate a long- or short-term capital gain or loss and that gain or loss will be reported on your tax return. A point of distinction: if you sell investments that are not inside a retirement account you can learn how to manage your capital gains and losses to reduce the taxes that you pay in retirement (to be covered in another blog post).

Not all retirement income is taxed

By now you may be asking if every dime you take in during retirement is taxed. The answer is, thankfully, “no.” Not every source of cash flow from investments is counted as taxable income. For example, if you own a bank CD that matures in the amount of $10,000, that $10,000 is not extra taxable income you need to report on your tax return, only the interest it earned must be reported. See, not all tax news is bad news!

How to pay fewer taxes in retirement

Your tax rate in retirement will depend on your total amount of income and your deductions. To estimate the tax rate, list each type of income and how much will be taxable. Add that up. Then reduce that number by your expected deductions and exemptions.

Everyone’s financial circumstances are different. Paying lower taxes in retirement may be feasible. It takes research or the assistance of a professional retirement planner or tax advisor.