Many people approaching retirement want to know what their tax situation will be like in retirement. They are working hard to jumpstart their savings and invest in various retirement accounts. It is, therefore, understandable that many of these people are concerned about taxes in retirement.
How will taxes affect your retirement income? What can you do to gain some tax advantages?
Taxes on Social Security Benefits
Social Security benefit is the monthly cash you receive from the Social Security Administration.
Only about 60% of people who receive social security benefits pay taxes on them. There are two ways to avoid paying taxes on social security benefits. If all of your retirement income comes from social security benefits, you will be exempt from tax.
If your provisional income (50% of your social security benefits and income from other sources like investments, retirement accounts, pension, and annuity) is below $25,000 for single filing and $32,000 for joint filing, you will receive your social security benefits tax-free.
If combined income exceeds $25,000 and $32,000 (for single and joint filing respectively), 50% of your social security benefits will be taxable. If those figures increase to $34,000 and $44,000, 85% of your social security benefits will be taxable.
In essence, if your combined income matches these figures, 50% or 85% of your social security benefits will be taxable.
The taxes mentioned above are federal taxes; some states (thirteen) also levy taxes on social security benefits.
Taxes on Other Income
Income from your retirement accounts is subject to tax. Most retirement accounts are tax-deferred accounts (the funds in those accounts are from pre-tax income); therefore, you will be subject to ordinary income tax when you withdraw funds from them.
Contrarily, withdrawals from Roth IRA and Roth 401 (k), among other Roth accounts, are not taxable because their contributions are from after-tax income.
Income from pensions is also subject to tax, as long as it is pre-tax income that went into the pension account.
Investment income, like dividends and interests, is also subject to taxation.
If you live in a state that levy taxes on personal income, all the incomes mentioned above will also be subject to state taxes.
Capital Gains Tax on Sales
When you sell your investments during retirement, the capital gains on the sale will be taxable. Although, if incomes from other sources are low enough, you can qualify for 0% capital gains.
Capital gains from your home sales will be subject to taxes only if the gain is more than $250,000 for single filing and $500,000 for joint filing (provided you lived there for at least two years).
Calculating your taxes
To calculate the taxes you will pay on your retirement income, you begin by adding the income subject to tax.
Let us take Carson as an example. Suppose Carson receives $20,000 from social security, withdraws $10,000 every year from his 401(k), and receives a pension income of $15,000. Since the combined income ($35000 – 50% of $20,000 plus $10,000 plus $15000) is greater than $34,000 (we assume single filing), 85% of Carson’s income will be subject to tax.
Therefore, taxable combined income equals $32,000 (85% of $20,000 + $10,000 + $15,000).
The next step is to subtract allowable deductions from the combined income. Standard deductions for single filers for 2020 is $12,400.
Carson’s taxable income will be $19,600 ($32,000 – $12,400).
Since Carson’s taxable income is less than $40,125, he falls into the 12% income tax rate bracket.
Therefore, for the first $9,875, he will pay 10% and for the remainder, he will pay 12%. Ten Percent of $9,875 is $987.5 and 12% of $9,725 ($19,600 – $9,875) is $1,167.
The total tax payable for Carson is $2,154.5.
Since Carson’s income falls below the 15% income tax rate, he can enjoy the 0% capital gains tax for all his capital gains in the applicable year.
Reducing Tax Liability
Financial planners have come up with some strategies to reduce your tax liability during retirement. Below are some examples:
- If possible, move to states that don’t tax personal income or states that don’t social security benefits
- Open and operate a Roth IRA or Roth 401(k) account: Opening this account will reduce your taxes in retirement since contributions to them are from after-tax income.
- If you are 72 and above, you can transfer funds from your traditional IRA to a charity account to avoid taxes.
- Consider investing in municipal bonds to reduce tax liability.
- Consider investing in stocks that pay qualified dividends.
- Seek the counsel of qualified financial advisors
Understanding the guidelines for the taxation of retirement income will help you know what to expect during retirement. Overstating your retirement income can be very bad (when you have to live with lesser funds than you planned). By understanding the income sources subject to tax and the deductions available, you will be able to create a concrete plan. You should also seek to implement some of the advice for reducing your tax liability.