Retirement Tax-Planning Insight
If you think retiring from the workforce means a break from paying income taxes, think again! For some retirees, income taxes are one of their highest retirement expenses. It’s important to be aware of your potential tax liabilities in retirement, and revisit annually, so that you can implement strategies to mitigate surprises and potentially decrease the amount of tax you owe in any given year.
First, know that you may fall into a different tax bracket once you retire, which could impact the amount of income tax you owe. Your tax liability is primarily influenced by three factors:
- Your filing status
- Your retirement income sources
- Your total annual income
It’s important to be aware of the following five taxes and how their treatment can affect your overall federal and state tax brackets in your retirement years.
1. Taxes on retirement account withdrawals
The tax treatment of retirement account withdrawals depends on account type. As you were working, you likely made contributions to traditional IRAs and 401(k)s with pre-tax dollars, thereby making withdrawals from these accounts subject to federal and state income tax based on your tax bracket in any given year.
Keep in mind that you must begin taking required minimum distributions (RMDs) from traditional IRAs and 401(k)s1 once you reach age 72. You do have the option to take your first withdrawal on April 1 of the year you reach age 73; however, that could result in a higher tax bracket that year as a result of taking two RMDs in one year.
By waiting until age 72 to begin taking RMDs, your mandatory distribution could be much higher than anticipated, depending on market growth in the years leading up to RMD age. This distribution, in addition to any investment income, rental income, Social Security and/or pension income, could push you into a higher tax bracket than you had expected. It’s wise to consult with your wealth manager to determine if tax efficiencies exist to start withdrawing from pre-tax retirement accounts prior to turning age 72. This includes strategies such as Roth conversions, which can take advantage of lower tax brackets in the years after retirement but before the commencement of RMDs and other retirement income.
In contrast to pre-tax retirement accounts, contributions to Roth IRAs and Roth 401(k)s are made on an after-tax basis, which results in different tax treatment for withdrawals. Assuming you’ve held the Roth account for at least five years and have reached age 59 ½, both contributions and earnings can be withdrawn tax free. There are no RMDs for owner Roth accounts (however, RMDs are required for inherited Roth IRAs).
2. Social Security taxes
If Social Security is your only source of retirement income, the amount you receive will likely be too low to be taxed. However, most people draw from additional income sources in retirement, such as part-time wages or self-employment income, investment income, retirement account distributions, rental income, etc., which, when combined, will likely trigger income tax on Social Security.
Your Social Security tax liability depends on your “provisional income,” which is the sum of:
- 50% of all your Social Security benefits for the year
- Your adjusted gross income (AGI), which is equal to your gross income, not including your Social Security benefits, minus any qualified deductions and exclusions
- Any tax-exempt interest income, such as the interest received on municipal bonds2
The following table summarizes the percentage of Social Security benefits that is taxable at different levels of combined income.
Social Security Income Tax Liabilities3
| Combined Income Amounts for Married Filing Jointly | Combined Income Amounts for Single or Married Filing Separately | Taxation |
|---|---|---|
| Up to $32,000 | Up to $25,000 | Social Security income is tax free |
| $32,001-$44,000 | $25,001-$34,000 | Up to 50% of Social Security income is taxable |
| More than $44,000 | More than $34,000 | Up to 85% of Social Security income is taxable |
3. Taxes on investment income
Long-term realized investment gains (applied to sales of assets held longer than one year) and qualified dividends are taxed at the current capital gains rate plus potentially an additional 3.8% net investment income tax for those with Modified AGI greater than $200,000 (single) or $250,000 (married filing jointly). Interest income is taxed at ordinary income tax rates. State income tax on investment income varies by state.
4. Taxes on pension income
If you receive periodic pension payments, your monthly income will generally be taxed at your ordinary income tax rate. Alternatively, if you choose to take a lump-sum payment, you could be subject to taxation on the total amount in the year you receive the payment (depending on terms of the pension and pre-tax versus post-tax amounts contained therein). This could potentially push you into a higher tax bracket.
5. Taxes on annuity income
Similar to pension income as mentioned above, the tax treatment of annuity income depends on how contributions were made. If contributions were made with pre-tax dollars, distributions are taxed at your ordinary income rate (for example, this would apply to an annuity held inside a traditional IRA account). If contributions were made with after-tax dollars, only the earnings are subject to income tax. The taxation of annuities can get very complex, so it’s best to consult with your wealth manager in the years prior to taking distributions.
Given the ramifications of income taxes in retirement, it’s also important to keep in mind that Medicare Part B and Part D premiums can be affected for those subject to higher income levels in retirement. Your income-related monthly adjustment amount (IRMAA) is a premium surcharge triggered by a modified AGI starting at $91,000 (single) or $182,000 (married filing jointly, adjusted annually for inflation. IRMAA premium increases can add up quickly for a married couple (with up to an additional $11,000 per year in Part B and D premiums applicable to the highest tier). IRMAA is assessed annually and based on your tax return two years prior to the current year. This illustrates the importance of annual tax planning in the years leading up to, and after, retirement, to prevent surprises and take advantage of strategies to mitigate these higher costs in retirement.
If you have questions about planning for tax liabilities in retirement, Creative Planning is here for you. We help clients establish tax-efficient retirement income streams to fund their retirement living expenses. For help with retirement tax planning, or with any other financial matter, schedule a call with a member of our team.
Footnotes:
- 401(k) RMDs are generally not required if you are still employed by the plan sponsor and do not own more than 5% of the business. Certain plans may require RMDs even if you are not retired.
- https://www.ssa.gov/pubs/EN-05-10035.pdf
- https://www.irs.gov/newsroom/irs-reminds-taxpayers-their-social-security-benefits-may-be-taxable
