Topics:tax preparation financial planning
Retirement is the dream. It’s about being financially independent, finishing work, and having more free time to spend with friends and family.
Unfortunately, taxes don’t go away.
“Many recent retirees are surprised to owe income tax time, because they are frequently not withholding on major sources of retirement income such as IRA distributions and Social Security benefits. You have to make withholding elections yourselves, with your planner or brokerage firm holding your IRA account, and by filling out Form W4-V to withhold from social security benefits. The typical working taxpayer has withholding taken care of by their employer, so they don’t expect to have to do this on their own come retirement,” says Bennett Stein, CPA and Investment Advisor Representative with Arbor Wealth Management, LLC.
Since you’ll be taking on a more active role in making sure your taxes are paid, it’s important to understand how retirement taxes work. It’s also worthwhile to understand retirement taxes when you’re young because it can help inform how you prepare your finances for retirement.
While you no longer have to pay FICA taxes, which are taxes withheld for Medicare and Social Security, you still have to pay income taxes on all of your income. The only exceptions are Health Savings Accounts and Roth IRAs.
Health Savings Accounts remain tax-free as long as the funds are used for medical expenses. However, the penalty for using the funds for other expenses goes away at age 65. Withdrawals for other expenses are considered taxable income. Roth IRAs are tax-free in retirement because the funds in those accounts are taxed before going into the account.
Everything else — investment income, retirement account withdrawals, pensions, annuities, and even Social Security Benefits — are taxed.
And, you still have to pay income taxes if you live abroad.
“America is one of two countries that enforces citizen-based taxation, so retirees will still need to submit the annual 1040s while sipping on cocktails on an island.
Many retirees are unaware of this filing retirement. Retirees should look to see the Tax Treaty between their new home and the U.S. to see which country has the taxing rights on their U.S. Social Security benefits and other foreign pension income. If the tax treaty states that the U.S. still holds taxing rights, then overseas retirees need to plan their money wisely, since they most likely be giving a portion of it back to the IRS every April 15th,” says Nathalie Goldstein, CEO of MyExpatTaxes.
Income tax during retirement is not just based on the total amount of income you withdraw each year. Instead, each kind of retirement income is taxed differently.
State taxes on retirement income also vary state to state. For more information on how income tax is applied in your state, check out this state-by-state guide.
“Once you hit the retirement age the heavily taxed monthly salary stops trickling in but you get to unlock several retirement income plans. These include savings, pensions, and investments and they too are taxed — but at more friendly rates. The rates are primarily dependent on the income source and the best approach to paying the taxes starts with understanding the different classification of your retirement incomes. Go through the IRA guidelines to check whether your incomes are taxable, partially-taxable, or tax-free and separate them accordingly as well as penalties and fines on early withdrawals,” says Edith Muthoni, Chief Editor of learnbonds.com.
Understanding how each stream of retirement income is taxed will help you better manage your retirement funds to make them last and get the most out of your funds.
Investment income is also taxed differently depending on how the income is classified and your total taxable income.
For some income levels, qualified dividends are not taxed. At others, qualified dividends have a tax rate of 15 or 20 percent. Qualified dividends are for funds and fund shares that have been owned by you for over 60 days.
Non-qualified dividends are taxed based on your income tax bracket’s normal rate.
People earn capital gains when the value of their investments rises. Capital gains are only taxable when they are realized from a sale. The taxes due on capital gains vary depending on how much long you’ve had the investment.
If you’ve had the investment for less than one year, the capital gains are subject to your usual income tax rate. These are called short-term capital gains.
If you’ve had an investment longer, the profits are called long-term capital gains. Long-term capital gains are taxed the same way as qualified dividends.
Interest is also taxed. Interest comes from bonds and some kinds of bank accounts, like savings accounts. All interest, even from mutual funds and bonds, is taxed as income.
Taxation of retirement accounts works differently. 401(k)s and traditional IRAs give people immediate tax breaks for contributing to their retirement account. The funds can grow tax deferred indefinitely. When withdrawals are made, the taxes must be paid at this point. These distributions are taxed as income.
In contrast, Roth IRAs do not offer immediate tax breaks on income. Instead, people pay taxes on the money they add to their Roth IRA. When they withdraw money later, they do not have to pay taxes on that income as long as the account is five years or older or a special exemption applies.
Penalties and taxes apply for early withdrawals from retirement accounts. Early withdrawals occur before age 59 and a half. For Roth IRAs, the penalties and taxes depend on the amount you withdraw.
Tracey Lawrence, Founder of Grand Family Planning, LLC
“Many people facing retirement don’t realize that when they turn 70.5, they MUST start taking Required Minimum Distributions from their retirement accounts whether they need to or not. Why? Because they have been growing their money, tax deferred. The IRS wants to start taking their cut. If they DON’T start receiving the RMDs on time, the retiree will be penalized 50 percent.
So you might think, okay, I’ll just take the RMD at 70.5 and avoid the penalty. Here’s what most people don’t realize: the amount of the RMD may have a significant impact on their income. Their income has an impact on the premium they will pay on Medicare.
How can they control how all of these interdependent mechanisms impact the cost of living in retirement? By working with professionals who understand how all of this works, who will look at the finances holistically BEFORE they turn 70.5. Many professionals are unaware of these issues, choosing to focus only on growing assets. While that may be desirable when we’re younger, understanding how to best distribute earnings later in life can keep people comfortable longer. And with people living longer, and health care costs continuing to rise, that’s extremely important.”
Edith Muthoni, Chief Editor of learnbonds.com
“You can also lower the impact of taxes on your retirement incomes by adhering to income access and withdrawal guidelines. For instance, avoid withdrawing from your 401K after changing jobs or before hitting 59.5 years as these attract early withdrawal penalties. Similarly, withdraw from both your IRA and 401K accounts before 70.5 years to avoid higher interest plus the possibility of losing up to 50 percent of these savings.”
HSAs are not taxed as long as the funds are used for medical expenses. In terms of retirement, HSAs start working like Roth IRAs at age 65. However, if the funds in the HSA are used for health expenses, they remain tax-free.
Pensions are similar to 401(k) and traditional IRA retirement accounts. The funds go into the accounts tax-deferred, so taxes are paid when distributions are made. Pension distributions are taxed as normal income.
With annuities, the value of the original principal is usually not taxable because they’re often bought after taxes. However, all the interest and value that accrues over time is taxed as income. If the annuity is purchased with tax-deferred dollars, the full annuity is taxed as income.
The taxes you pay on Social Security benefits are determined based on how much other income you receive. In some cases, Social Security is tax-free. However, most people will have to pay tax on 50 or 85 percent of their Social Security benefits.
Denise J. Nostrom, ChFC, CLU Financial Advisor at Diversified Financial Solutions
“Paying taxes on retirement income really depends on the type of income you are receiving. For most people, it makes sense to withhold federal and state taxes (if applicable) right from the income source. These income sources can include, but are not limited to the following: Social Security, Pension and Traditional IRAs. Before retirement, when you received your paycheck from your job, you had federal, and state taxes withheld plus Social Security, Medicare and perhaps other items withheld from your gross income. You should follow this same system in retirement.”
Nancy D. Butler, CFP ® , CDFA ™, CLTC and owner of Above All Else, Success in Life and Business ®
“I strongly suggest all retirees do not pay quarterly income tax payments.
One of the main concerns we all have as we age is how we can maintain our independence and happiness as long as possible. One way to assist with that is how you manage paying your income taxes. If you are paying quarterly estimated federal and/or state income taxes, it may not be necessary. As we age, remembering how much to pay, when to pay it, where to send payment, and how much postage costs is an issue you most likely do not have to deal with.
Contact your tax advisor and have him or her calculate how much to have withheld from your pension, Social Security, or qualified plan assets so you no longer have to file quarterly estimated income tax returns. Each year when you have your income taxes prepared, your tax advisor will need to let you know if you need to adjust the amount for the coming year.
This will enable you to have your taxes paid automatically to better assure they are paid in the correct amounts and on time. This will be one less thing you will have to address.”
Patrick Ford, CPWA ® Director of Wealth Management of Brown Wealth Management
“Other retirement income sources can get a bit tricky. Withholdings might not be appropriate, so you may need to pay estimated taxes to the IRS on a quarterly basis. A non-retirement account may contain a variety of securities which can generate capital gains, losses, dividends, tax-free income, taxable income, etc. Because withdrawals from these accounts are not taxed as income, retirees with non-retirement accounts typically estimate their tax bill and make payments on a quarterly basis to the IRS. It’s the activity within these accounts that matters for tax purposes.”
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