3 Ways You Are Taxed In Retirement

Ever since you got your first job you’ve probably hated paying taxes.  They are a staple of life while you work and for most people that doesn’t stop in retirement.  While it’s true that your overall taxes usually go down in retirement that doesn’t mean they go away.  Let’s discuss some different types of income you can receive in retirement and how they will be taxed.

1.  Social Security – If you have worked for at least 10 years you should qualify for Social Security benefits.  In retirement, depending on your income, your benefits may or may not be taxed.  At worst, only 85% of your Social Security benefits will be taxable.  Here is how it breaks down:

• file a federal tax return as an "individual" and your combined income* is
• between $25,000 and $34,000, you may have to pay income tax on up to 50 percent of your benefits.

o    more than $34,000, up to 85 percent of your benefits may be taxable.

• file a joint return, and you and your spouse have a combined income* that is
• between $32,000 and $44,000, you may have to pay income tax on up to 50 percent of your benefits

o    more than $44,000, up to 85 percent of your benefits may be taxable.

* Source: http://www.ssa.gov/planners/taxes.htm 

Follow the link above to see an example of how to calculate your “combined income.”

2.  Pensions/401k/IRA Distributions – Distributions from your retirement accounts or monthly payments from a pension will be taxed like ordinary income.  You will owe taxes at your marginal tax rate on each additional dollar you take out of your IRA/401k.  Any withdrawals from a Roth IRA will not be taxed federally or by the state as long as it is a qualified withdrawal.  Many states allow exemptions on some or all retirement account distributions. New York, for example, doesn’t tax the first $20,000 withdrawn from each individual’s retirement account each year.  Also, many states don’t tax your pension if you worked for the state.

Fortunately, we get to choose how much we withdraw from our retirement accounts each year, or at least until you turn 70 ½.  Once you turn 70 ½ you are required to take a certain amount out of your IRA/401k each year.  The amount you are required to take is based on the value of your account at the end of the previous year divided by a factor.  You can find the factor by referring to the IRS uniform life expectancy tables listed here:

http://www.irs.gov/pub/irs-tege/uniform_rmd_wksht.pdf

Source: IRS

3.  Capital Gains & Qualified Dividends – If you have a taxable brokerage account with investments you will owe taxes on the dividends, interest and capital gains realized each year.  Depending on your tax bracket you may owe taxes at your marginal tax rate on the interest, non-qualified dividends and short-term capital gains.  Your qualified dividends and long-term capital gains will be taxed at 0%, 15% or 20% depending on how high your income is.  If your income is high enough you may also face an additional 3.8% tax.  Here is a nice recap of the various tax brackets and rates depending on the source and amount of income:

http://www.schwab.com/public/schwab/nn/articles/Taxes-Whats-New

Source: Charles Schwab & Co.

Conclusion: Retirement is one of the biggest tax planning opportunities you will get and it’s worthwhile to spend time thinking about your cash flow.   Many retirees can manipulate which accounts they take money from to minimize their taxes.  The difference can add up to thousands of dollars of tax savings each year.