As you approach retirement, you will need to make sure that you are financially secure enough to stop working. When estimating the amount of money they will need to retire, many people forget to account for certain costs and issues, such as inflation.
Another expense that people often overlook is taxation. Retirement income does get taxed, and the amount depends on the city and state you live in. Importantly, taxation in retirement also depends on the vehicles that you used to save. You can plan strategically to reduce your tax burden in retirement, but the first step in doing so is to understand exactly how different types of retirement income get taxed.
1. Social Security Benefits
Some people are surprised to learn that they need to pay taxes on the Social Security benefits that they receive, or at least on part of the income. Overall retirement income received by an individual or a couple will dictate the amount of tax paid on Social Security benefits.
If your individual total income is between $25,000 and $34,000 or if you are a joint filer and your number is between $32,000 and $44,000, you can be taxed on up to 50 percent of your benefit, while income above these levels can be taxed on up to 85 percent. Importantly, married couples that file separate returns will pay tax on all Social Security income.
The IRS offers worksheets that you can use to figure out what portion of Social Security is taxable and how much you might owe in taxes on income once you retire.
2. IRAs and 401(k)s
Traditional accounts get taxed at the federal level. This should not be surprising, as most retirees make pre-tax contributions to their accounts. The whole point of a traditional IRA or 401(k) is to defer the tax payment until a later date, when income will likely be less, translating to a lower taxation rate.
Taxes on withdrawals from these accounts are due as soon as the money leaves the account. You may have wondered if you pay taxes on the whole amount withdrawn or only on the portion that you contributed, considering that employers also often make contributions to 401(k)s and similar accounts, such as a 403(b). The answer is that you are responsible for taxes on the whole amount withdrawn. Roth accounts consist of post-tax money, and thus no taxes are due when the funds are withdrawn (provided that you adhere to the IRS rules). Also, these accounts need to be held for five years before the tax-free provision is honored.
Retirees with a pension will also pay income on the withdrawals they take from that account. Both pension annuities and pension payments will trigger tax payments due at the regular federal rate you pay. If you decide to take a lump-sum payout from your pension instead of payments, you need to pay the total tax due on the amount within the year that you receive the money. However, you can choose to transfer this lump sum into an IRA, which will allow you to defer taxes until you begin to withdraw funds from it.
Remember that taxes on pensions vary by state. Some states do not tax pension income at all, so you can maximize your income by moving. Tax rate is based on current physical location, not the state in which the pension was earned.
4. Taxable Accounts
The taxes due on taxable investment accounts, meaning those that are not specifically marked as tax-advantaged retirement accounts, can get quite complicated. The interest paid out on investments in these accounts is taxed at the regular federal rate for the taxpayer, but other income, such as dividends and capital gains, are taxed at the long-term capital gains rate (as long as the account has been held for one year).
This rate is usually lower than the federal tax rate, varies between 0 percent and 20 percent, and depends on the overall tax bracket. The lower tax rate, in addition to the fact that they allow you to take income from the accounts before retirement without any penalty, makes these accounts appropriate for retirees.
Sometimes, you can use capital losses on investments to offset capital gains and minimize tax burden. Plus, you can bunch or defer income to a specific tax year or take advantage of various credits and deductions.
5. Gifts and Bequests
Before retiring, you should also think about the tax ramifications of gifts and bequests. Transferring wealth in the right way is key to avoiding estate taxes, which can actually be significantly higher than normal tax rates. Plus, various states have an inheritance tax on assets that are inherited from an estate rather than specifically gifted.
You can make gifts up to a certain amount to anyone you wish without paying any taxes. The ceiling is set by the IRS and changes frequently, so it is worth checking into the current maximum before making gifts. You can also make larger gifts to beneficiaries without paying taxes provided that you comply with IRS rules. Doing this reduces your taxable estate while preserving wealth for your beneficiaries.