Here's How Your Taxes Will Change When You Retire
When most people dream about their retirement, they focus on the places they'd like to travel, the hobbies they'd like to spend time on, and the people they will see more of. Pondering how to deal with taxes in retirement generally does not enter into these sorts of reveries.
While everyone should plan for the good stuff in retirement, it's also important to recognize the less fun aspects of retiring — like taxes. If you are prepared for the financial side of retirement, then you'll be better able to enjoy your time.
Here's what you need to know about how your taxes will be different post-retirement.
Understanding Your Tax Bracket
Before discussing how your taxes change in retirement, it's a good idea to understand both what your tax bracket is and what that means for the amount of money you owe. As of 2017, these are the federal tax brackets for ordinary income:
Tax Rate Married Filing Jointly Most Single Filers
10% $0–$18,650 $0–$9,325
15% $18,651–$75,900 $9,326–$37,950
25% $75,901–$153,100 $37,951–$91,900
28% $153,101–$233,350 $91,901–$191,650
33% $233,351–$416,700 $191,651–$416,700
35% $416,701–$470,700 $416,701–$418,400
39.6% $470,701+ $418,401+
What these tax brackets describe is your marginal tax rate, which is the rate you pay on the highest portion of your income. For instance, if you are single and fall in the 25% tax bracket, you are not taxed 25% on all of your income. You are taxed 25% on any income above $37,950, you are taxed 15% on any income between $9,326 and $37,950, and you are taxed 10% on any income below $9,325.
The Tax You Will No Longer Pay in Retirement
Let's start with the good news. There is one type of federal tax that retirement income and Social Security income are both exempt from. That's the Federal Insurance Contributions Act (FICA) tax, which funds Social Security and Medicare.
Employed individuals see 6.2% of their gross earnings taxed for Social Security through FICA (and their employers also kick in 6.2%, making the total tax contribution 12.4% of each earner's gross income). In addition to Social Security, FICA also collects 1.45% of your gross income for Medicare Part A.
Once you retire and you are no longer earning income from employment, then all of your income will be exempt from FICA — even any income you take from tax deferred accounts, such as 401K accounts or traditional IRA accounts. That's because your contributions to these accounts were already subject to FICA taxes, even if you funded the account with pre-tax dollars.
The Taxes You Will Owe on Tax-Deferred Accounts
Tax-deferred accounts, like 401Ks and traditional IRAs, allow workers to set money aside before Uncle Sam takes any income tax (although FICA taxes are deducted before the money is placed in such accounts). That money grows tax-free, and once the account holder reaches age 59½, they can take distributions from it without any penalty.
However, the money will then be considered ordinary income and taxed accordingly. So that means a single retiree's $30,000 distribution from their IRA will place them in the 15% tax bracket, and they will owe $4,033.75:
10% of $9,325 = $932.50
15% of $20,675 = $3,101.25 ($30,000 - $9,325 = $20,675)
$932.50 + $3,101.25 = 4,033.75
The other important thing to remember about tax-deferred accounts is that you will have to take required minimum distributions (RMDs) once you reach age 70½. That's because the IRS does not want you to hold onto the money, tax-free, forever. Once you reach 70½, you must take the RMD amount every year, or owe the IRS 50% of the amount you should have withdrawn. The RMD is calculated based on your date of birth, the balance of each tax-deferred account as of December 31 of the previous year, and one of three IRS distribution tables, and it is taxed as ordinary income.
No Taxes on Roth IRA and Roth 401K Distributions
The Roth versions of IRAs and 401Ks are also tax-advantaged, but the tax burden is front-loaded. That means you invest after-tax dollars into your Roth account, the money grows tax-free, and any distributions taken after you have reached age 59½ and have held the account for at least five years are completely tax-free.
This is one of the reasons why many retirement experts recommend investing in both traditional and Roth tax-advantaged accounts, because it offers you tax-savings both during your career and once you reach retirement.
Capital Gains Taxes
Any investments you have made outside of tax-advantaged accounts — such as stocks, bonds, mutual funds, and real estate — are taxed as capital gains, which is great news for many investors.
That's because long-term capital gains tax rates, which apply to assets you have held for a year or longer, are quite low. For any investor in the 10% or 15% tax bracket, long-term capital gains taxes are a very favorable 0%. Investors in the 25% through 35% tax bracket will only owe 15% on long-term capital gains, while those in the 39.6% tax bracket owe 20% on long-term capital gains.
Short-term capital gains, on the other hand, are taxed at your ordinary income tax rate, as is the interest on your savings account and CDs, as well as dividends paid by your money market mutual funds.
Taxes on Your Social Security Benefits
Up to 85% of your Social Security benefits may be subject to income tax in retirement. The higher your non-Social Security income in retirement, the more likely it is that you'll owe taxes on your Social Security benefit.
The way the IRS determines whether your benefits are taxable is by calculating something known as provisional income. The formula for determining the provisional income is: one-half of your Social Security benefits, plus all your other income, including tax-exempt interest. (While tax-exempt interest is included in this calculation, tax-free distributions from a Roth IRA are not.)
This means that the more money you take from your retirement accounts, the more of your Social Security benefits are considered taxable.
Taxes on Pensions and Annuities
Pensions from both private companies and the government tend to be taxed as ordinary income, unless you also contributed after-tax dollars to your pension.
As for annuities, the tax on your annuity will depend partly on how you purchased it. For instance, if you used pre-tax dollars (like from an IRA) to purchase your annuity, then your annuity payments will be taxed as ordinary income. However, if you purchased the annuity with after-tax dollars, then you will only be taxed on interest earned. With each annuity check you receive, a portion will be considered non-taxable principal, and a portion will be interest that is taxed at your ordinary income tax rate.
Diversifying Your Taxes
Most people recognize that diversifying investments is a sound strategy for growing wealth. However, it's also a good idea to diversify your taxes — that is, make sure you will not be paying all of your taxes at the same time.
Many workers only contribute to tax-deferred retirement accounts, which means they will be facing large tax bills in retirement. It makes more sense to understand when and how you will owe taxes on your various sources of retirement income, and try to diversify the tax burden.
Taking a small tax hit now, by investing a Roth account or making other investments with post-tax dollars, will help make sure you are not overwhelmed by your tax burden once you retire.
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