How are taxes different in retirement?

Will your tax bill get some much needed time off when you retire? Unfortunately, the short answer is no. The IRS plans to continue working full time. Don’t worry; we’re here to walk you through some of the key tax considerations you should be aware of in retirement.

Social security benefits

Your paycheck was already taxed once to contribute to Social Security, so you should be done with that, right? It depends. Social security benefits have been subject to federal taxation since 1984, and your taxes are calculated based on your combined income.

What is my “combined income”?

  • Your adjusted gross income;
  • plus nontaxable interest;
  • plus ½ of your social security benefits.

If you file a federal tax return as an “individual” and your combined income is

  • between $25,000 and $34,000, you may have to pay income tax on up to 50 percent of your benefits.
  • more than $34,000, up to 85 percent of your benefits may be taxable.

If you file a joint return, and you and your spouse have a combined income that is

  • between $32,000 and $44,000, you may have to pay income tax on up to 50 percent of your benefits.
  • more than $44,000, up to 85 percent of your benefits may be taxable

If you are married and file a separate tax return, you will probably pay taxes on your benefits. This is unless you have lived separately from your spouse for the entire year.

Regular 401(k) and IRA distributions

Be sure to check out the following article for help deciding when you may want to take distributions from your 401(k).

Once you start taking distributions from your regular 401(k) or IRA account, they will be taxed as ordinary income. That means the distributions will be taxed at the same income tax rate as your payroll check. The reason for this is that contributions to regular 401(k) and IRA accounts are made with pre-tax dollars. Your taxable income is reduced by the amount of your contribution to your retirement account in the year you make it. Then, you pay taxes when you start taking out the money later. Don’t forget that if you withdraw cash from your retirement plan before age 59½, you may be subject to an additional 10% penalty. There are some exceptions; however, these are typically reserved for hardships related to certain medical expenses and disabilities that prevent you from working.

Roth 401(k) and IRA distributions.

A Roth 401(k) or IRA account works differently than a traditional retirement account. You make contributions to these accounts with after-tax dollars. This means your taxable income is higher in the year you make your contributions. The good news is that you generally don’t have to pay taxes when you later make a qualified withdrawal from a Roth 401(k) or IRA. That means your gains in a Roth account are tax-free.

A qualified withdrawal is one that meets the following two criteria:

  • First, you must be aged 59 ½ or older.
  • Second, your first contribution must have been made at least five years ago.

If these two prerequisites are met, there are no taxes or penalties assessed on your withdrawal of either contributions or earnings. The primary difference between a Roth 401(K) and IRA is that you have to start making withdrawals from a Roth 401(k) after you turn age 70½. This is true unless you are still working for your employer. Roth IRAs do not require withdrawals until after the death of the owner.

Some strategic approaches for tax planning in retirement

Looking for a bit of guidance for your tax planning? Here are a few ways to think about reducing or deferring your taxes in retirement.

Regular vs. Roth retirement accounts

The different tax treatment of regular 401(k) and IRA accounts vs. Roth 401(k) and IRA accounts means you can choose between paying taxes now or during retirement. Planning how you will use these options may decrease the total amount you pay in taxes. Here are some ways to look at it:

  • If your tax rate will be significantly lower in retirement, a traditional account may be your best choice because you will pay a lower tax on your withdrawals.
  • If your tax rate will be significantly higher in retirement, a Roth account may make sense because qualified withdrawals are tax free.

It could also make sense to contribute to a mix of traditional and Roth accounts if you can. This would allow you to choose between taxable and tax-free withdrawal options when it comes time to take distributions during retirement.  

Consider the order in which you withdraw from your retirement accounts

The order in which you withdraw funds from your various retirement accounts can help you avoid penalties, pay lower tax rates in the near term, and possibly defer taxes altogether. The following withdrawal approach attempts to address all three of these opportunities:

  1. First, make any required minimum distributions (RMDs) from a traditional IRA or 401(k). RMDs are minimum amounts that an individual must withdraw annually from a traditional 401(k) or IRA at age 70½ or, if later, the year in which he or she retires. If a retiree does not make his or her RMDs, then the amount not withdrawn is taxed at 50%. That’s a huge penalty, so you definitely want to avoid it by following the mandated amounts, which you can find in this page on the IRS website.
  2. Second, look at any taxable investment accounts you may have, such as a brokerage account with stocks and bonds. Typically, you will have to sell investments from these accounts to convert them into cash. You’ll also pay capital gains taxes on any appreciation of these investments. If you’ve held the investment for longer than a year, you’ll generally be taxed at long-term capital gains rates. Most taxpayers have long-term capital gains rates that are lower than their ordinary income tax rates, which is why you might consider investment accounts as your second source of retirement funds.
  3. Next, look at your traditional traditional IRA and 401(k) accounts again, because by reducing those accounts first, you will leave the remainder of your money in tax-advantaged Roth accounts, where it has the potential to grow tax deferred and be withdrawn on a tax-free basis in the future.  
  4. Finally, look at your Roth accounts for withdrawals on a tax-free basis.  Roth IRAs do not have RMDs. Your money can compound tax free in a Roth IRA until your death, but you will have to start removing it from a Roth 401(k) at age age 70½.  Your heirs will also benefit from inheriting a tax-free Roth account vs. a traditional retirement account which will be subject to tax.

The strategy outlined above may not be the best for everyone. Sometimes too many withdrawals from a tax-deferred retirement account can cause you to move into a higher tax bracket. Make sure to discuss the details of your circumstance with a qualified tax advisor who can help you avoid paying more than your fair share of taxes in retirement.  

Should I move to save on taxes?

Some people move to another state after retirement in order to pay fewer state and local taxes. For example, seven states do not tax personal income (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming), and two other states (New Hampshire and Tennessee) tax only dividend and interest income. Five states charge no sales tax (Alaska, Delaware, Montana, New Hampshire, and Oregon).
However, there are a variety of factors to consider before loading up the moving van.  Property, local sales and inheritance taxes, as well as general cost-of-living expenses can vary significantly by location. In addition, state and local laws on taxes can change over time depending on the government’s financial situation and the politics of the day. For more information about how costs can influence where you choose to live in retirement, check out the following article.

Be sure to consult a tax and financial advisor before you decide to move so that you can fully consider all of the implications. Remember: taxes are just one of the factors that will determine your quality of life in retirement.

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Read our quick-start guide for help, including which questions you should be asking as you approach retirement.

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