Carnegie Investment Counsel Blog

Getting a Grip on Income Taxes in Retirement

Posted by Carnegie Investment Counsel on Apr 14, 2022 2:00:00 PM

Getting a Grip on Retirement Taxes

You’ve spent the last few decades toiling away at your job or running your own business. You’ve provided for your family and possibly created jobs for others at the same time. And you have certainly been paying income taxes over that same time frame, probably ever since your dad got you that summer job that paid you the minimum wage.

As your retirement years come into focus, it’s a good bet that you’re looking forward to stepping away from the everyday grind of your family business or profession. Maybe you also believe that you will be walking away from paying Uncle Sam his share of your retirement income. That popular misconception is certainly not the case.

While retired Americans generally pay less in income taxes than other age groups because of a reduction in income, the tax burden can still be a significant line item in their budget.

Many different income streams in retirement, including Social Security benefits, are subject to federal and possibly state income taxes. This discussion, though, will focus on tax liabilities at the federal level. The amount of tax you will be required to pay is at least partly a function of how much income you will receive once you stop working. Let’s explore the primary sources of retirement income and what tax burden they carry.

 

Social Security Benefits

Beginning in 1984, Social Security beneficiaries whose income exceeded certain levels have been required to pay income tax on a portion of their benefits. If you have retirement income that is not tax-exempt, from a traditional IRA, for example, your tax liability is calculated by combining a portion of your Social Security income along with the proceeds from that IRA.

If your total income is below $25,000 and you file as an individual, your Social Security is not taxable. For individuals, if your combined income is in the $25,000–$34,000 range, up to half of it is taxable. If your income is higher than that, then up to 85% of your benefits may be taxable. If you and your spouse file jointly, you’ll owe taxes on up to half of your benefits if your joint income is in the $32,000–$44,000 range. If your income is above that, then up to 85% is taxable income.

Comprehensive reforms implemented by Congress in 1983 set the income thresholds for determining when Social Security benefits are to be considered taxable income. Because the legislation never indexed the thresholds to prices or wages, the number of retirees that pay federal tax on their benefits has risen significantly over time.

In fact, over the last 35+ years, this tax-paying club has become much less exclusive. According to the Social Security Administration, the share of beneficiary families whose benefits are taxed has risen over that time from less than 10 percent to more than 50 percent today.

 

IRAs and 401k Accounts

Generally speaking, if you received a tax deduction when you made contributions to a traditional IRA, the proceeds or distributions from that IRA will likely be taxable. The primary variable is your level of total income and your tax bracket. This is no different than the tax rates you are experiencing before retiring since the same basic tax brackets apply to all taxpayers.

In the same way, distributions from other qualified retirement vehicles like a 401(k) or 403b account that are funded with pre-tax contributions are taxable once you begin to draw on the account. For a more complete discussion of tax brackets and what constitutes taxable or nontaxable income, see IRS publication #554, The Tax Guide for Seniors.

 

Pension Income

If you were fortunate enough to participate in a defined benefit retirement plan during your working years, you will find that you will have to pay taxes in the year that you take the money. These funds will be taxed as ordinary income, as you receive the money from pension annuities or as periodic payments. Bear in mind though, that if you take a direct lump-sum payout from your pension, you will be required to pay the total tax due on the full amount. This may not be advisable in most instances. But if you transfer that same lump sum directly to an IRA within 60 days, taxes will be deferred until you begin to withdraw the money.

 

Taxable Investment Accounts

Many retirees will also have investment accounts that are fully taxable, like a brokerage or bank account. Interest income will be fully taxable at the regular rate but dividend income and gains taken on investments held for at least one year are taxed at the long-term capital gains rate of between 0 and 20 percent, depending on your tax bracket.

Another salient feature of taxable accounts is that required minimum distributions (RMDs) are not applicable. RMDs only apply to retirement plans. While retirees must begin to draw down their retirement plan accounts at age 72, they are under no obligation to take a distribution from a taxable investment at any age. This flexibility may be important for some investors as they make decisions on which of their accounts to utilize for income and which to retain for use later.

 

Managing Your Income Taxes in Retirement

By analyzing your sources of income, an investment advisor will be able to estimate your federal and state income taxes in retirement, along with expected deductions, and estimated taxes in the years ahead. The advisor will be able to estimate how much of your Social Security income will be considered taxable.

Additionally, that advisor can help you understand the impact of RMDs on your tax situation. While Congressional action suspended RMDs for the 2020 tax year, it is unlikely that they will be suspended in the future.

Lastly, consider talking to an advisor if you are thinking about converting a traditional IRA into a Roth account. A financial professional can help determine your tax obligation on the front end of a conversion and estimate the tax benefit when you begin taking distributions down the road. For more information, contact us to book an appointment

 

Additional Resources for Income Taxes in Retirement:

Investopedia.com, "How Is Social Security Taxed?"

SSA.gov, "Income Taxes on Social Security Benefits"

IRS.gov, "Tax Guide for Seniors"

Investopedia.com, "Long-Term vs. Short-Term Capital Gains: What's the Difference?"

IRS.gov, "Retirement Plan and IRA Required Minimum Distributions FAQs"

 

Need a Retirement Advisor?

If you are currently looking for help with retirement planning, contact us. We are happy to schedule an introductory meeting at your convenience.

Book an Appointment

 

Topics: Retirement Planning, Taxes

Carnegie Investment Counsel

Written by Carnegie Investment Counsel

Carnegie Investment Counsel is an Registered Investment Adviser (RIA) providing personalized financial guidance to help you preserve and grow your wealth, so you are freer to enjoy your life. As your fiduciary, we are obligated to place your investing success ahead of our returns.

    carnegie top 4 things 2021 version-1

    Looking to hire a Financial Advisor?

    Enclosed in our eBook are four questions we recommend you ask any prospective group you review. Plus, you'll learn: 

    • The difference between fiduciary and suitability standards
    • Learn how some advisors may not be required to work in your best interest
    • Be aware of various types of hidden costs
    • The importance of third party custodians
    • The difference between fee-based and fee-only

    Download Now, It's Free

    Recent Posts

    Subscribe here for monthly blog updates!