tax brackets

Here's How Your Taxes Will Change When You Retire

Emily Guy Birken — Thu, 09 Mar 2017 10:30:37 +0000

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.

This article is from Emily Guy Birken of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

3 Ways More Money in Retirement Might Cost You

Emily Guy Birken — Wed, 08 Mar 2017 10:00:10 +0000

You might think that there is no such thing as too much money in retirement. After all, without a steady income from working, you need your retirement nest egg to last you throughout your golden years. So more money must be better, right?

Well, as The Notorious B.I.G. once said, the more money we come across, the more problems we see — even in retirement. While I would never discourage anyone from saving as much as they can for retirement, it is a good idea to recognize what kinds of additional problems a large retirement portfolio could cause you.

Here's what you need to know about the potential pitfalls of having more money in retirement:

1. You Will Owe Taxes on Tax-Deferred Retirement Accounts

According to the Bureau of Labor Statistics, as of December 2016, 44% of all workers were participating in a tax-deferred defined contribution plan, such as a 401K or an IRA. These types of retirement accounts allow workers to put pretax dollars aside for their retirement, where the money grows tax-free. Once you reach age 59½, you may withdraw money from such tax-deferred accounts without penalty.

The potential trouble comes from the fact that any distribution you take from your tax-deferred account is taxable as ordinary income. This means that you will be taxed on that income in the same way you would be taxed on the same amount of income from a job. Because of the taxes you will owe on your distributions, the money in your tax-deferred retirement account is worth less than the dollar amount.

Since many workers anticipate having a lower tax bracket in retirement than they do during their career — that is, they expect to have a much lower retirement income than career income — it makes sense to put off the taxes they will pay on the money in their 401K or IRA until after retirement. However, for anyone who manages to create a large retirement portfolio from a modest salary during their career, the tax burden in retirement will be much larger.

2. Required Minimum Distributions May Force You to Withdraw Money You Don't Want

If you put money aside into a tax-deferred account, the IRS will want to see its cut of the money eventually. For that reason, the IRS requires each account holder to begin withdrawing money during the year that he or she reaches age 70½. There is a minimum amount you must withdraw, and the IRS levies a stiff penalty for failing to do so — you will owe 50% of the amount that should have been withdrawn.

In addition, the required minimum distribution 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. That means your required minimum distribution must be recalculated each year using your new end-of-year balance from the previous year and your new distribution period according to the IRS distribution table. Getting the amount wrong can be potentially costly, and if you have a great deal of money in your tax-deferred accounts, you will be required to take more money than you necessarily want to access in one year.

Don't forget, this required minimum distribution is also taxed as regular income (as we discussed above), so in addition to potentially withdrawing money you don't want, you will also owe taxes on the amount that you are required to withdraw.

3. You Will Be Taxed on Your Social Security Benefits

Many people are unaware of the fact that up to 85% of their Social Security benefits may be subject to income tax in retirement. The higher a retiree's non-Social Security income, the more likely it is that they will owe taxes on their Social Security check.

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.)

Your provisional income is compared to an upper and lower base amount to determine how much of your Social Security benefits are taxed, if any. If you file as single, then your lower base amount is $25,000. If your provisional income is above that amount, then you owe taxes on 50% of your Social Security benefits. The upper base amount for single filers is $34,000. If your provisional income is above that amount, then you owe taxes on 85% of your Social Security benefits.

What this means is that the more money you take from your retirement accounts, the more of your Social Security benefits are considered taxable.

For instance, if you are single and you take $38,000 from your IRA in retirement each year, then you are in the 25% tax bracket and you owe taxes on 85% of your Social Security benefits since your income is above the upper base limit. If you decide to withdraw an additional $1,000 from your IRA one year, your additional $1,000 in income will cause $850 more of your Social Security income to be considered provisional income, making it subject to taxation at your marginal tax rate of 25%. You'll owe $462.50 on your $1,000 withdrawal ($1,850 x 25% = $462.50) between your IRA taxes and your Social Security benefit taxes.

More Money in Retirement Is a Good Problem to Have

Though having a large nest egg may cause some headaches after your retirement, it's important to remember that this is a better problem to have than facing retirement without enough savings. Just recognize that large amounts of money need to be properly managed and you need to stay on top of your financial life post-career. You can handle each of the financial problems that you may see with a larger retirement portfolio, as long as you are aware of them and prepared for them.

This article is from Emily Guy Birken of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Tax Brackets Explained

Julie Rains — Fri, 22 Jun 2012 10:24:13 +0000

Being in a high tax bracket seems to be something that people envy (in others) but avoid (for themselves). But what does that mean, and what does it matter? (See also: 15 Surprising Facts About Income Tax)

Here’s what to know about tax brackets:

Your tax bracket is based on taxable income (not your annual salary) and filing status with the IRS (such as Single or Married Filing Jointly)
The percentage associated with your tax bracket is your marginal tax rate
The percentage associated with your tax bracket is not the same as your average or effective tax rate
You may be able to move to a lower tax bracket by making contributions to a tax-deferred investment account such as an IRA and 401(k); making charity contributions; or selling stock held in regular accounts at a loss
Selling stock at a gain may move you to a higher tax bracket, even if your earned income stays the same

IRS Tax Brackets

Generally, when people talk about tax brackets, they are referencing income levels associated with IRS (federal) tax rates for ordinary income tax and not other types of taxes or withholdings for state and local taxes. Federal income rates and tax brackets change periodically. To give you an idea of current tax brackets, consider these income levels and percentages using information from IRS Publication 505, Tax Withholding and Estimated Tax.

2012 Tax Brackets by Taxable Income

Single Filing Status

10% – less than $8,700
15% – between $8,700 and $35,350
25% – between $35,350 and $86,650
28% – between $86,650 and $178,650
33% – between $178,650 and $388,350
35% – over $388,350

Married Filing Jointly

10% – less than $17,400
15% – between $17,400 and $70,700
25% – between $70,700 and $142,700
28% – between $142,700 and $217,450
33% – between $217,450 and $388,350
35% – over $388,350

What Difference Your Tax Bracket Makes

Your tax bracket determines your marginal tax rate. This percentage can be important when considering financial decisions. Specifically, knowing the marginal tax rate helps you to determine the impact of certain actions (such as making a charitable contribution or making an IRA contribution) on your cash flow.

In trying to understand precisely what “marginal” in marginal tax rate means, I came upon several definitions. The one that made the most sense to me described “marginal” as being the one on the top margin of your income. (Definition from the Dictionary of Financial Terms from Lightbulb Press)

For example, if you itemize deductions and you are in the 25% tax bracket, then a charitable donation of $1,000 will “cost” you $750; that is, you give away $1,000 but get a tax break of $250. Similarly, if you are in the 35% tax bracket, then you could reduce your tax bill by $350 for the same contribution.

Likewise, putting money away in an IRA or 401(k) can have tax benefits. These benefits can be measured by your marginal tax rate. A $2,000 contribution might help you to reduce your tax liability by $200 if you are in the 10% tax bracket or $500 in the 25% tax bracket. When you reduce your taxable income, you may move to a lower tax bracket if you happen to be on the edge of a bracket.

Marginal Tax Rate vs. Average Tax Rate

You pay taxes based on a combination of tax rates (unless you are in the lowest tax bracket, and then you pay based on the lowest rate only). That is, taxpayers don’t pay federal income tax that is equal to their taxable income multiplied by their marginal tax rate. Just a portion of your income is taxed at this higher rate.

To determine your average tax rate, you need to calculate how much your taxable income is taxed at each level.

For example, if you are single and your taxable income is $50,000, then your tax calculation (using Publication 505 to estimate your tax liability) is $4,867.50 + 25% x ($50,000-$35,350) = $8,530.00. Or, you can calculate this dollar amount by applying various tax rates to portions of your income, like this:

Portion 1: $8,700 x 10% = $870
Portion 2: ($35,350-$8,700) x 15% = $3,997.50
Portion 3: ($50,000-$35,350) x 25% = $3,662.50
Total of All Portions = $8,530.00

Then take the total tax amount and divide by taxable income to calculate the average rate. In this case, the average tax rate is 17.06% ($8,530 / $50,000).

Average Tax Rate vs. Effective (or Actual) Tax Rate

Now that you see how the marginal rate differs from the average rate, consider how the average rate varies from your effective or actual rate. The actual rate (federal income tax liability divided by annual income) is less than marginal and average tax rates when you consider that your taxable income is much less than your actual income.

Here are some of the factors in determining taxable income.

Income

For many people, annual income is simply your annual salary or total of yearly wages. But income can also include earnings from a side business or freelance gigs, unearned income from interest and dividends, capital gains from the sale of stock, sweepstakes' winnings, unemployment compensation, and payments from pensions. (For a complete list, review IRS Form 1040 (PDF) and instructions (PDF), call the IRS, or talk to your tax professional.)

Qualifying Expenses and Contributions

Certain expenses and contributions are deducted from income. These may include Health Savings Account (HSA) deposits, student loan interest deductions, contributions to IRAs, and self-employment retirement plans. Certain credits are also available, further reducing tax liability.

Exemptions and Deductions

Your income is reduced by exemptions (personal and dependent) and the standard deduction (PDF) or itemized deductions.

So, your taxable income may be $50,000, but your actual income could be $50,000 + $3,700 (personal exemption for 2011) + $5,800 (standard deduction for 2011) or $59,500 (more if you made contributions to your IRA, 401(k), or HSA). In this case, your actual federal income tax rate is 14.34%. You will probably pay other taxes, like state and local taxes, so if you want to get a complete picture of your tax rate, then add up all taxes and divide by your income.

Capital Gains and Tax Brackets

Long-term capital gains from the sale of investments like stocks and mutual funds not held in tax-advantaged accounts are taxed at special rates. Through 2012, these long-term gains have a tax rate of 0% for those in 10% and 15% tax brackets and 15% for those in tax brackets of 25% and above. Qualified dividends are also taxed at these favorable rates.

Income from long-term capital gains is included in taxable income, so you can’t sell lots of stocks for a profit and expect to pay nothing in taxes. However, if you have relatively low income and sell some mutual funds at a gain, then you may be able to benefit from this tax arrangement.

Short-term capital gains (held for one year or less) and ordinary dividends are treated as ordinary income and taxed at regular rates.

When retirees take money out of their Roth accounts, they pay no taxes on qualified distributions (under current tax laws). Compare that to ordinary tax rates for distributions from traditional IRAs and 401(k) accounts.

So both the amount and the type of income that you have can impact your actual tax rate. That’s why some people can have high incomes but lower than usual tax rates.

Have you ever made a financial decision based on your tax bracket? Share in the comments.

This article is from Julie Rains of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: