With today’s complex tax rules, taxes in retirement can be a nightmare. Retirement accounts come with many tax traps that even the most careful investors may fail to see. Therefore, it shouldn’t be a shock that some retirees might be paying more taxes than necessary. Now that you have put together your retirement nest egg, it’s time to verify that you aren’t giving Uncle Sam more than you owe.
To help you evaluate your taxes in retirement, here are some of the most asked questions I get as a financial planner about taxes in retirement. Use this blog as a tool to see how much you understand about your current or future tax situation.
Many people make their retirement plans with the idea that they will fall into a lower tax bracket once they hit retirement. But this isn’t usually the case for the following reasons:
Retirees’ homes are usually paid off so there’s no mortgage interest deduction. Most retirees don’t have any kids to claim as dependents or retirement account contributions to reduce their income. Therefore, almost all of a retiree’s income will be taxable during retirement.
If you are newly retired, you may want to travel and do hobbies that you didn’t have time to do before. Depending on your travel and hobby expenses, your income might be the same as it was pre-retirement.
Considering today’s political climate and growing national debt, future tax rates may be higher than they are today.
There’s a good chance that you will not owe any taxes in retirement if Social Security is your only source of income. However, if you have other sources of income, a portion of your Social Security benefits may be taxable. More than half of Social Security beneficiaries pay some tax on their benefits.
The amount of your taxable Social Security benefits depends on your total income or the sum of:
Retirees can contribute to a traditional or Roth IRA if they earn money from a job. Anyone over 50 years old can contribute up to $7,000 to an IRA for 2022. However, you can’t contribute more than what you have earned to your IRA account.
Unlike a traditional IRA or 401(k), Roth IRA contributions are paid upfront and are tax-free once you retire. However, it is essential to understand that you must be over age 59.5 and have held the account for at least five years before making tax-free withdrawals.
If you complete the rollover following the IRS guideline, no tax will be imposed. There are two ways to process a tax-free rollover from a 401(k) plan to a traditional IRA:
Once you have withdrawn money from your 401(k), you have 60 days to deposit the funds into the IRA account. I usually don’t suggest this route for most clients because if you miss the 60-day deadline, the withdrawn funds will be considered taxable income. In addition, exceeding the time limit can impose a 10% early withdrawal penalty if you are not at least 59.5 years old.
In a direct rollover, the custodian or plan administrator transfers the funds from one account to another. Since no money is placed in your hands, there’s no withholding or early withdrawal penalty.
The portion of the annuity disbursement that represents your initial investment (your principal) is tax-free, but the rest is at your ordinary income tax rate. For example, if your initial investment is $100,000 and you receive $20,000 per year for the next 10 years (or $200,000 total), 50% of each payment will be taxable. The insurance company that sold you the annuity will be able to tell you how much taxes you owe.
If you bought an annuity using pre-tax funds (such as a traditional IRA), 100% of your disbursement will be taxed at your ordinary income rate. Please be aware that you will be taxed at your income rate, not at the desirable capital gains rate.
Generally, those with traditional IRAs and 401(k) accounts are required to start taking required minimum distributions (RMDs) at age 72. If you have already started withdrawing money from your retirement accounts, you can skip the next two sections about RMDs.
As for the amount you are required to withdraw: Your RMD rate will likely start at about 3.65% of your account value and will continue to increase every year. To figure out your RMD withdrawal percentage check out this RMD calculator.
If you have multiple traditional IRAs, RMDs must be calculated separately for each IRA but can be withdrawn from any of your IRA accounts. In contrast, if you have several 401(k) accounts, your RMD must be calculated for each 401(k) account and withdrawn separately from each account.
For this reason, 401(k) administrators may calculate your RMD and automatically send it to you if you haven’t withdrawn the funds by a specific date.
Normally, the requirement is to take RMDs at the end of each year after you turn 72. However, for your first RMD, you don’t have to make a withdrawal until April 1st of the year after you turn 72. If you delay the first withdrawal until April 1st, you’ll have to make a second distribution by end of the year.
Since you will be paying taxes for two RMDs in one year, you will have to be careful to ensure that you don’t bump into a higher tax bracket.
If a loved one dies and you get a big life insurance payout, you will not have to pay taxes on the money as a beneficiary.
If the value of your estate is less than $12.06 million, the 2022 threshold amount, then there is no federal estate tax due. As a result, estate taxes aren’t an issue for many families. The 2017 estate tax reform doubled the threshold temporarily. However, it is likely to drop back to $5 million in 2026.
Even though you may not have any federal estate taxes, you might owe state estate taxes instead. Twelve states and the District of Columbia charge state estate taxes and six states impose inheritance taxes.
How are you preparing for taxes during retirement? What are you most worried about when it comes to taxes in retirement? Taxes in retirement can be complicated, is there anything that you are interested to know?
This is based on U.S. tax, not always the case in other countries