Everything You Need to Know About Taxes in Retirement
When you get ready to retire, there are many things that you will be leaving behind such as the commute to work, the busy schedules, daily grind and possibly the old home that you used to live in. One thing that never leaves you during retirement is your tax bill. In retirement, your income taxes could be the biggest expense. It is important to know how retirement income works and how it is taxed.
Some people continue to work while in retirement. If you are one of those people, then you should be aware of how much money you should save prior to actually retiring. If you are in retirement already, you may still need to plan for the years ahead so you can avoid your money running out. You should get a better understanding of how your taxes will impact your retirement; pursuing techniques that will lower your tax bill and increase your retirement income. You won’t be able to avoid taxes in retirement.
Social Security Benefits
If you are an older American, you may be surprised to know that you owe taxes on some of your Social Security income received. The taxes you pay will be dependent on the amount of retirement income you receive as well as your spouse. It doesn’t even matter if you file separate or joint tax returns. You may be wondering why this is the case if you used to pay Social Security taxes when you were working. Many of you are thinking that your Social Security taxes, which were withdrawn from your paycheck for so many years should be enough. It can be very discouraging, but let’s explain. If you were getting $5,000 per month while working, 6.2% would be the tax rate for social security.
What It Means?
What does this mean as it relates to taxes in retirement? It means the employer would keep back $310 out of your monthly pay; sending it to the federal government. Additionally, the employer would also make a similar contribution of 6.2% of your monthly pay. Just so you know, the employer contribution is not taxed. In the above example, Social Security in the amount of $620 is non-taxed; the contribution from the employer and the other from you. The government holds on to the $620 until you file a Social Security claim for retirement benefits or when you turn 62 years old.
Income Taxation
When you do retire and if your Social Security benefit is the only income you are receiving, it won’t be taxed because that income is way too low for taxation. However, if you are receiving $2,000 from pension and $3,000 from IRA, you may have to pay taxes owed on it. The reality is that the contributions made to the federal government don’t have your name written on it and I addition, you won’t get the exact money back from what you contributed.
Collecting Taxes
In fact, there are many employees that get back much more during retirement. It is still true, though, that the federal government does not generally collect taxes from the money you earn while you are working. All the government does is to hold on to the contribution for you. The higher your income, though, the more contribution you have to make towards your social security benefits. It can range from 50 percent to 85 percent according to your income. Whether you are married or filing your returns separately, you get no tax break. The IRS has worksheets that will help you know what part of that income is taxable and how much you will owe the IRS on the income from your retirement or pension.
Things might seem confusing in the concept of ‘combined income.’ The ‘combined’ portion is where it might be difficult to understand. “Combined’ means that the amount includes adjusted gross income, half of the social security benefits and the non-taxable interest income. You can use an income and tax tracker to help you understand this better.
Adjusted Gross Income
Adjusted gross income is the total income subtracted from your income adjustments. The most commonly used gross income sources are salaries, interest, tips, dividends, wages, pensions, 401K/IRA distributions and annuities. The most commonly used adjustments are deductions, deductions for student loan interest, paid alimony, contributions to health savings account, self employment contributions to retirement plans.
Taxes Paid on Pension Income
It is required that you make tax payments on your pension and on the withdrawals you make from investments that are tax deferred. This includes 403(b), IRA contributions, 401K and similarly related retirement plans and annuities that are tax deferred. It is usually within the same year that the money is made or withdrawn. The taxes due will lessen the amount remaining to spend.
Withdrawing From IRA
Federal income tax will be owed, but it will be at the normal rate of the amount received from the pension annuities. However, if you withdraw a lump sum from the pension, you will have to pay the entire taxes due to the government upon filling your tax return in the same year you received the money; whether you use tax preparation services or not. In either of these cases, your employer is usually going to withhold taxes as you make the payments. Therefore, some of the amount due will be considered prepaid. If a lump sum is transferred to your IRA, the taxes become deferred as long as you don’t withdraw any of the funds. If you do start withdrawing funds from your IRA, then you will be taxed.
State to State Variations
Taxes you pay on your pension income will usually vary from state to state. To ensure you are doing the right thing when it comes to paying taxes on retirement, it is best to check the tax rules of the state you live and work in. There are certain states where your pension payments are not taxed while other states do. That is why some people consider relocation when they are ready to retire. If you relocate to another state, the state where you worked is not able to tax your pension payments that you earned. For example, if you used to work in a state like New York and you moved to live in Florida, which is a no-income tax state, you wouldn’t owe any income tax payments on your pension to New York.
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Taxes Paid On Your 401K and IRAs
Not everyone has a 401K or IRA, but those who do must be responsible when taking income out of the traditional IRA or 401K. If you were to take out income from your IRA, you would owe taxes on anything earned from the IRA, which is being withdrawn and this would be at the normal tax rate. If you have deducted any part of your IRA contributions, then you will owe the government taxes at a similar rate on the entire amount of the withdrawal. The IRS Publication 590 has instructions on how you can calculate the money you would owe.
Roth IRA
With a Roth IRA, no taxes will be owed on all accumulated earnings, but you should have had the account for a minimum of five years prior to qualifying for tax free interest and earnings. Income received from traditional 457 salary reduction plans, 403(b)s, and 401ks, you must pay taxes on the entire amounts. These types of income are all produced by combining contributions from you, your employer and earnings derived from the contribution itself and are all taxed at the normal rate. Be aware that the contribution withdrawals and the Roth 401K earnings are not allowed to be tax as long as the IRS withdrawal requirements are met.
Taxable Account Management
The interest that you pay on investments in your taxable accounts has a regular tax rate. However, other forms of income from qualifying dividends and capital gains is taxable at the long-term rate; between 20% and 0%, but it also depends on the person’s tax bracket. This is the same scenario for those who have had investments in excess of a year. One of the most important benefits of taxable accounts is their lower tax rate on most earnings. Taxable accounts have no withdrawal requirements nor do they have tax penalty for obtaining income from them prior to turning 59½ years of age. For that reason, you have more flexibility to decide which one of your investments you will tap into for income and which one of them you will let stay for later.
Get Recommendations From A Professional
You do have certain ways that you can lessen the amount of taxes that you may owe. Capital losses on certain investments can be used to offset or compensate for your capital gains on other investments. You can get more explanation about this from your tax professional. You should get more details on how you can combine or defer the income to one tax year or how to take advantage of credits and tax deductions. You may also ask for investment recommendations that can pay less current income, but with strong potential for growth.
Other Recommendations
These recommendations could include managed accounts, index funds, real estate, mutual funds, exchange traded funds and individual securities. Your tax professional could also recommend charitable gift giving of your valuable assets. With this technique, you will be allowed to avoid paying capital gains taxes and you get to take a tax deduction for the present value of your assets. Income taxes cannot be avoided during retirement. However, once you are no longer working, you won’t have to pay Medicare and Social Security taxes on retirement, which can total several thousands of dollars.
Income Sources
Below are some retirement income sources that are typically not taxed:
Municipal Bonds: the interest income that comes from having municipal bonds is tax free. However, you may be subjected to paying state taxes.
Reverse Mortgage: the income received from reverse mortgage is tax free. These are usually lump sums or from monthly payments. Many people overlook this hidden advantage that reverse mortgages give.
Principal or cost basis return: once you withdraw all your capital gains from your annuity, it would affect your principal or cost basis withdrawal. Your cost base withdrawal does not count for taxable retirement income.
Selling a home: In most circumstances, gains made from selling a home are not usually taxable. However, this is only when it is less than $250,000, if you are single and if you are married, it has to be less than $500,000. You must also have resided in the home for two or more years of the previous five years. There are also other IRS requirements to be met.
Estates, Assets and Gift Giving
Your future is an important aspect of retirement planning. Giving away some of the assets you have could be a benefit to you as the giver and for the receiver as well. In addition, in doing so, you get to downsize and live comfortable with less assets to maintain on your retirement income. Another good way of relieving yourself of paying estate taxes is transfer of wealth. With estate taxes, you will pay high taxes on assets that are not transferred. In fact, in some states, you have to pay inheritance taxes on retirement at different rates on the amounts received by your heirs from the estate. Before death, the good news is that you can give gifts to anyone you wish. This can be done up to a specific amount without having to pay taxes. From time to time, this amount changes according to the IRS fluctuating tax rules. Over your lifetime, you can give larger gifts to beneficiaries and pay no tax on the amount.
Conclusion
You are likely to pay taxes on retirement if your taxable retirement income is above the tax threshold each year. The question is the amount you will pay. Your tax burden can be minimized as a retiree, but you may need the help of a professional. Some of the strategies that professional uses include bundling the income and itemized deductions, distributing the time and converting retirement accounts.
It is best to consult a tax professional to learn which if any retirement income has the potential to be taxed and at the specific taxable rate. In doing so, you will avoid IRS audits and penalties.