What You Need to Know About Estimating Taxes in Retirement

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Income is income, in retirement or otherwise, and where there is income, there is tax. Even though your income in retirement will be coming from different sources, such as IRAs, pensions, or social security, in most cases you’ll still be responsible for paying taxes on what you receive or withdraw.

Many, if not most, retirees rely on multiple different sources of income to fund their golden years including, but not limited to, the following:

• Social Security Income
• Pension Plans
• Traditional IRA and 401(k) withdrawals
• Roth IRA or Roth 401 (k)s withdrawals
• Investment Income

Each type of income incurs unique tax rules and liabilities and will affect your take-home amount in different ways. In order to minimize the tax burden on your overall income and accommodate for those taxes in your budget, you’ll need to understand how each different type of income is taxed.

Social Security Income

The amount you are taxed on your social security income will depend on the amount of income you have coming in from other sources, but ranges from 0%-85%. If social security benefits comprise your only source of retirement income, you likely won’t be taxed at all.

If you have other sources of income, though, as most of us will, the IRS will determine your taxable amount based on a calculation of your “combined income.” By taking ½ of your Social Security benefits and adding them to all your other income, including tax-exempt interest, you can find your “combined income” amount. The higher your income level, the larger percentage of your benefits that will be federally taxed; however, the taxable amount does not exceed 85%.

Keep in mind that these 13 states also asses taxes on social security benefits, though some offer deductions or exemptions based on age and income: Minnesota, North Dakota, Vermont, West Virginia, Colorado, Connecticut, Kansas, Missouri, Montana, Nebraska, New Mexico, Rhode Island, and Utah.

For many, deciding when to take benefits is the toughest decision to make regarding social security. You are eligible to begin taking benefits at age 62, but you incur a permanent penalty on all your distributions. So while taking benefits early means you will receive benefits for a longer period of time, it also means you receive a reduced amount. On the other hand, if you defer payment past your Full Retirement Age (FRA), you may be eligible for delayed retirement credits resulting in a slightly greater benefit amount.

But when it comes to your tax liability and your need to start accepting social security benefits, the decision should not be made in isolation. You’ll want to consider the tax liability of your social security benefits in the context of your overall income tax obligation in order to avoid seeing a hefty tax bill once the benefits start coming in.

Pension Plans

Pension plans are either fully taxable or partially taxable, based on whether or not the funds put into the account were deposited pre-tax or post-tax. Pre-taxed funds are subject to income taxes when they are withdrawn, while after-tax funds are not. Essentially, if you already paid taxes on the contributions, you will not be taxed on them again. For example, if an employer made contributions to your pension plan that were attributed to you as income at the time, you will have already paid taxes on those contributions and will not be taxed a second time.

Traditional IRAs and 401(k) Withdrawals

Most withdrawals from traditional IRAs (that is, non-Roth IRAs), 401(k)s, 403 (b)s, 457 plans, and thrift savings plans are taxed in retirement since these plans are tax-deferred, meaning that taxes were not assessed on contributions to these accounts in your working years. For the most part, distributions from these accounts will be taxed as ordinary income, much like a regular paycheck would.

Tax-deferred retirement accounts reduce the amount of income tax paid when the contributions are made, but can be particularly burdensome when withdrawal income is added to other income sources.

How will your tax-deferred withdrawals affect your overall income taxes? Will your Required Minimum Distributions (RMD) push you into a higher tax bracket? Will the increased income affect your “combined income” in such a way that pushes your social security taxation into a higher tier? These are the types of considerations that make strategically planned withdrawal timelines and tax preparation in retirement so important.

Essentially, the more funds you expect to receive from tax-deferred assets, the more you’ll need to save to cover the taxes that will accompany them. Many pre-retirees make the mistake of contributing so much to traditional IRA and 401 (k) accounts, that they become “tax-deferred rich.” That is, they accumulate so much in their tax-deferred accounts that they see a huge tax bill at 70 ½ when they are required to start taking RMDs. Diversifying your retirement savings strategies can help you avoid this scenario.

Roth IRAs and Roth 401 (k) s

Unlike the traditional IRAs discussed above, qualified distributions from Roth IRAs are excluded from taxation since the funds were already taxed upon contribution. But in order for a distribution to qualify for this exemption, two requirements must be met:

1) The distribution must occur at least five years after the owner began funding the IRA, and

2) One of the following:
• The individual is 59 ½ years of age or older
• The Roth IRA holder becomes disabled
• The assets are distributed to the beneficiary upon the owner’s death
• Withdrawal is used for a qualified first time home purchase
• Withdrawal is disbursed for higher education expenses on behalf of the owner, owner’s spouse, children, grandchildren, or great-grandchildren

Since qualified distributions from a Roth IRA don’t count against an individual’s gross income, they don’t threaten bumping an individual into a higher tax or social security tax bracket.

Roth 401 (k) s operate in the same manner except when it comes to employer contributions made pre-tax. In this case, the employer contribution is treated like a traditional 401 (k); the owner will be responsible for paying income taxes on the employer’s pre-tax match as well as any growth associated with that match when distributions are taken.

Another way to reduce your retirement tax liability is by rolling over your traditional IRA funds to a Roth IRA, otherwise known as a backdoor Roth conversion. While you will pay tax on any pre-tax dollars upon conversion, your withdrawals in retirement will be tax-free. This is especially helpful for investors who anticipate being in a higher tax bracket later in life.

Roth IRA conversions are also helpful for pre-retirees whose high income disqualifies them from opening or contributing to a Roth account. Even though these high-earners don’t qualify for a Roth, they are legally eligible to roll over, or convert, any amount of their traditional IRA funds into a Roth once a year.

Investment Income

For tax purposes, dividends, capital gains, and interest income are treated no differently pre-retirement than they are in retirement. But naturally, the main difference is that many retirees rely more heavily on their investment income in retirement than they did in their saving years, subsequently increasing their tax liability.

Investment income is taxed based on the way in which it produces income. Income can either be generated (a) while the owner holds the investment by means of interest, dividends, or rent, or (b) upon the appreciated sale of the asset. The former is generally considered ordinary income and will be taxed like any other source of revenue; the latter is subject to long-term or short-term capital gains tax, depending on whether the asset was held for over or under a year’s time.

While no one ever wants to pay more in taxes than is absolutely necessary, proper tax planning is even more critical in retirement. You’ll want to ensure you outlive your assets without having to drastically alter your lifestyle.

Decisions such as when to begin taking social security benefits or how to handle your Required Minimum Distributions can greatly affect your overall post-tax income and should not be approached without suitable care and consideration.

If you would like to analyze your tax liability during retirement or plan a retirement income strategy, we at Harbor West would be more than happy to discuss your options. Contact us today to learn how we can help you lay the groundwork for a well-funded and rewarding retirement.

This information is provided for general purposes and is subject to change without notice. Every effort has been made to compile this material from reliable sources; however, no warranty can be made as to its accuracy or completeness. Before acting on any of the information, please consult your Financial Advisor for individual financial advice based on your personal circumstances. Neither Harbor West nor Geneos Wealth Management, Inc. provide tax or legal advice.
Harbor West is a division of NorthEast Community Bank. Securities and Advisory Services offered through Geneos Wealth Management, Inc. FINRA/SIPC Investment Advisory and Financial Planning Services offered through Geneos Wealth Management, Inc. Investments are not FDIC Insured. Investments are not deposits of the financial institution and are not guaranteed by the financial institution. Investments are subject to risks including loss of principal.



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Regulatory Disclosure: The information on this website has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. This website is neither an offer to sell nor a solicitation to buy any securities. Gerard Gruber offers Securities and Investment Advisory and Financial Planning service through Geneos Wealth Management, Inc, Member FINRA/SIPC.  Investments are not FDIC insured. Investments are not deposits of the financial institution and are not guaranteed by a financial institution. Investments are subject to investment risks including loss of principal amount invested.