One of the things many people are unprepared for when they retire is how to manage their tax burden. Contrary to popular belief, most retirement income is not exempt from income taxes. However, with the right planning and strategies you can reduce your tax burden well into your retirement years. Here are some things you should know about retirement taxes.
Almost All Income Sources are Taxable
Social Security, pension income, and distributions from traditional 401k and IRA accounts can be subject to income taxes depending on your income level. Pretty much the only retirement income source not subject to taxes is Roth IRA distributions because you paid taxes on it before contributing to the Roth IRA and then it is allowed to grow tax free.
According to the Social Security Administration, “Some people have to pay federal income taxes on their Social Security benefits. This usually happens only if you have other substantial income (such as wages, self-employment, interest, dividends and other taxable income that must be reported on your tax return) in addition to your benefits. Those filing as an individual earning between $25,000 and $34,000, or a joint return joint return earning between $32,000 and $44,000, in combined income* may have to pay income tax on up to 50 percent of their benefits… But, no one pays taxes on more than 85 percent of their Social Security benefits.”
*Your combined income is your adjusted gross income plus non-taxable interest plus half of your Social Security benefit.
You need to plan for how to manage new income sources and how you plan to pay taxes on them. If you have a good income aside from Social Security you might consider postponing collecting Social Security since your benefit increases the longer you postpone taking it. With current interest rates so low your future income may actually grow better by letting the government keep the money rather than paying taxes now and trying to invest it yourself. Remember that paying taxes on 50% of your benefits is not the same as paying 50% of your benefits in taxes. So if you need the money and are earning $38,000 a year plus collecting $1000 / month in Social Security you would pay taxes on $6,000 of the Social Security since $38 + $6 is less than $44,000. The tax rate for a couple earning $44,000 is approximately 13% or $5681. So on the taxed $6,000 in S.S. you would pay $775 of that back in taxes. For every dollar you earn over $44,000 however you would pay taxes on 85% of the Social Security. So on the first $100 dollars over $44,000 you would pay 13% of $85 or about $11 dollars more in taxes.
Just like with an employer you can have the Social Security department withhold taxes on whatever they pay you. One thing to be careful of is retiring mid-year because your earnings in the first half may put you above the threshold and cause you to pay tax on the Social Security received during the second half. Another tax trigger is when one spouse in a couple retires and starts receiving benefits while the other spouse continues to work.
Tap Non-taxable Sources First
At some point, you more than likely are going to have to start paying taxes on your retirement savings. Traditional IRAs and 401k plans both require minimum distributions starting at age 70 1/2. But you can start withdrawing as early as 59 1/2 without penalty. If you have money stashed in a Roth IRA, you might consider taking it out first since Roth distributions are not taxable in retirement, so by taking your Roth money first, you further postpone taxes. However, you should seek professional help in determining the best way to reduce taxes and avoid penalties because the laws are complex and you might end up being penny wise and pound foolish by saving a few hundred in taxes and then being liable for many thousand in penalties if you don’t properly meet the withdrawal requirements.
Large Estates Should Consider Life Insurance
If you have a large estate (over $5.45 million for 2016), you might need to consider methods of shielding the estate from estate taxes. Currently, the estate and gift tax exemption is $5.45 million per individual or $10.9 million per couple. If your estate is above that and you plan to leave money to children or other heirs when you die, you might consider getting a whole life insurance policy to help shield some of the money. If you simply leave your heir’s cash, stocks, property or even a business, they may have to pay taxes on the inheritance. However, up to a point life insurance proceeds are tax-free. Also, if you get the right kind of policy, you may be able to use some of the money in the form of a loan or tax-free distribution, although doing so may lower the benefit that goes to your beneficiary. Estate planning lawyer David Carrier recommends that anyone with a larger estate should seek professional help to make sure you set up everything correctly and keep everything above board and prevent problems after you are gone.
Move to a Lower-tax State
Many people who move to places like Florida during retirement do so for the climate, but there is another good reason: lower taxes. Florida has no income tax and very low property taxes. You pay income and other taxes in retirement based on where you currently live, so if you move somewhere with low taxes, it could mean more money you get to keep.
Currently, seven U.S. states don’t have a state income tax. They are:
- Alaska
- Florida
- Nevada
- South Dakota
- Texas
- Washington
- Wyoming
Residents of Tennessee and New Hampshire are exempt from state tax on earned income although they do pay tax on dividends and income from investments which would probably hurt retired people while helping working people.
Retirement should be the time in your life when you get to relax and enjoy the money you saved through years of hard work. Being aware of how taxes affect you in retirement and actively managing the situation can leave you better off.
