If you're approaching retirement, you've probably put some thought into how your life will change once you retire -- but you may not have considered how your taxes will change, too. It may not be pleasant to dwell on the taxes you'll have to pay in retirement, but putting in a little advance thought gives you the best chance to minimize those taxes.
Retirement account distributions
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Tax-deferred retirement accounts, including traditional 401(k)s and IRAs, are a great deal when you're saving for retirement, because the contributions to these accounts come out of pre-tax dollars. However, once you retire, it's time to pay the piper -- aka the IRS -- because distributions from these accounts are taxed as income (Roth account distributions, on the other hand, are not taxed).
During your working years, the total amount of your taxable income determines what tax bracket you fall into and therefore how much income tax you pay on that money. During retirement, calculating your income tax works much the same way, except you no longer have an employer to take that money out of your paycheck for you. So when you plan your retirement account distributions, take into consideration the taxes you'll need to pay on that money.
Given that you've probably been sitting on the money in your tax-deferred retirement accounts for decades, the IRS is understandably eager to get its mitts on its share of that money. So once you reach age 70-1/2, you're required to start taking withdrawals from your tax-deferred retirement accounts. These required minimum distributions (RMDs) are set by the IRS based on your expected lifespan, and you have to take them every year. If you fail to withdraw at least the amount of your RMD from your tax-deferred accounts in a given year, you'll get hit with an extra tax in the amount of 50% of what you failed to take. For example, if your RMD for the year was $10,000 and you only took $8,000 out of your IRAs, you would owe the IRS an extra $1,000 (that's 50% of the $2,000 you failed to take). That's in addition to the normal income taxes that you'll pay on all distributions from tax-deferred retirement accounts.
Social Security benefits
Social Security benefits aren't the free ride that many retirees expect. If Social Security is your only source of income, then you'll be scot-free on taxes, but it's a rare retiree who can survive on Social Security benefits alone. Most likely, your income will come from several different sources, including taxable ones such as the aforementioned tax-deferred retirement accounts. And once your taxable income reaches a certain amount, your Social Security benefits become partially taxable as well.
The income threshold is equal to one-half your Social Security benefits for the year, plus your nontaxable interest, plus all taxable income. If this adds up to $25,000 or more (for single filers) or $32,000 or more (for joint filers), you'll have to pay taxes on at least some of your Social Security benefits.
Pensions and annuities
Most pensions and annuities are at least partly taxable. Any money you invested in a pension or annuity that came out of post-tax dollars is not taxable, but the remainder is. Calculating the tax on partially taxable payments can get awfully complicated, but the good news is that your pension or annuity provider will usually do the math for you and tell you how much of the benefits are taxable on the 1099-R form they send you every year. The provider will also withhold what they think you owe in federal taxes and send it to the IRS for you, but the withheld amount may not be enough if you have a lot of taxable income from other sources.
For example, if your annuity pays you $2,000 per year, the annuity provider will typically withhold 10% of that, or $200. However, if you have a lot of other taxable income, you will probably end up in a higher tax bracket than 10%. As a result, you may end up owing more taxes on that $2,000 when you prepare your tax return for the year. That's something to keep in mind when factoring income from these accounts into your retirement budget.
If you've been following a buy and hold investing strategy, you probably don't have to pay a lot in capital gains taxes. But once you retire, your focus will change from building capital to generating income, which means you'll probably do a lot more selling than you did in your working years. Any capital gains that pop up inside tax-advantaged retirement accounts are not taxed, but if you sell investments from a standard brokerage account, you'll have to pay capital gains taxes on any profits. Fortunately, if you've been hanging on to those investments for a while (at least 366 days), you'll have long-term capital gains taxes to pay; these are considerably lower than short-term capital gains taxes.
Federal income taxes will probably be your biggest tax burden in retirement, but they won't be the only taxes you have to pay. Retirees also face state income taxes, property taxes, and even local taxes. That's why it can be helpful to hire an experienced tax professional to do your tax return. They'll likely be able to save you some money on your income taxes, reducing the strain that all these taxes put on your wallet.
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