Navigating the Impact of Retirement Income Taxes
When it comes to planning for retirement, taxes probably aren’t the first thing that comes to mind – but understanding them is necessary for developing the best possible retirement income strategy. Let’s take a look at how your retirement income can be taxed and why it’s important for you to know the implications that apply to your particular situation.
The Different Types of Retirement Income
Many people think that once you retire, money stops coming through the door. For most, that’s not exactly the case and for some, it’s actually quite the opposite. Retirement income can takes many forms, each with its own pros and cons:
Social Security benefits: Income funded through payroll taxes collected from workers and their employers.
Pensions: Income from retirement plans established by employers based on factors such as the individual's earnings, years of service, and the specific rules and calculations of the pension plan or program in which they are enrolled.
Retirement account withdrawals: Income derived from the retirement accounts you have been contributing to over the course of your life.
Real estate: Income generated through rental income or real estate investments.
Dividends and capital gains: Income from corporate financial gains via payments to shareholders or an increase in stock value.
Part-time job or self employment: Income generated through working post-retirement either part time or for yourself.
How Are Social Security Benefits Taxed?
In order to take full advantage of your social security benefits, it’s important to understand how they are taxed. This knowledge will help you better choose how to spend your time and money and help you enjoy retirement with less financial stress.
Step 1: Determining provisional income
Your provisional income helps dictate how much your social security will be taxed. Calculate it by adding up your adjusted gross income (AGI), nontaxable interest, and one-half of your social security benefits.
Step 2: Understanding taxation thresholds
Taxation thresholds help decide at which rate you will be taxed, based on your provisional income. The IRS describes it in more detail.
You will pay tax on only 85% of your Social Security benefits, based on Internal Revenue Service (IRS) rules. If you:
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% of your benefits
More than $34,000, up to 85% 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%of your benefits.
More than $44,000, up to 85% of your benefits may be taxable.
Are married and file a separate tax return, you probably will pay taxes on your benefits.
Taxing Retirement Account Withdrawals
Despite what many think, withdrawing money from your retirement account can in fact carry a tax burden with it. Depending on whether you have a traditional or Roth IRA, you may be taxed on your withdrawals. Here’s the distinction:
Traditional IRA: Withdrawals from a traditional IRA are generally subject to income tax. When you withdraw funds from a traditional IRA in retirement, the distributions are treated as ordinary income, and you will owe taxes on the amount withdrawn at your regular income tax rate.
Roth IRA: Qualified withdrawals from a Roth IRA are tax-free. To be considered qualified, the Roth IRA must have been open for at least five years, and you must be at least 59½ years old, permanently disabled, or using the funds for a first-time home purchase (up to a certain limit).
Understanding the Impact of RMDs
Required minimum distributions (RMDs) can heavily influence your retirement budget and how much you pay in taxes. They are mandatory withdrawals from retirement accounts, such as Traditional IRAs and 401(k) plans, once the account holder reaches a specific age (currently 72 years old for most individuals).
Tax implications vary depending case by case. Typically, they take into account a person’s income, RMD history, Medicare history, and other factors that influence a person’s financial standing. Regardless, the IRS counts RMDs as taxable income so at the very least, everyone pays income taxes on them.
Other Tax Considerations in Retirement
Just when you think you’ve checked all the boxes and thought of everything that could possibly carry tax implications, there’s more to be considered. Do you have an estate plan? Will you be inheriting any money? Inheriting generational wealth almost always carries a tax burden along with it, so it’s important to consider any type of inheritance you may receive that could add income to your retirement.
And just because you’ve officially retired doesn’t mean you have to stop working completely. Many individuals retire and pick up some part-time work or become self-employed, generating an additional source of retirement income. What’s more, if you are involved in charitable giving during your retirement, you may actually qualify for tax deductions, offsetting some of the potential implications. It’s an intricate process that requires time, attention, and patience.
How We Can Help
While these are general guidelines about the impact of taxes on retirement income, the truth is that every situation is unique. At Dekker, we’re experts in navigating the retirement income tax landscape, and prioritize learning about your particular needs, goals, and circumstances, so we can help you best mitigate tax implications and better prepare you for the next exciting chapter in your life. To learn more, get in touch with our team here!