Know What to Expect From Taxes in Retirement

So, you’re saving money for a financially secure retirement. Good for you! Just make sure you’re not overlooking one of the biggest factors that could make or break your nest egg: taxes.

Many retirees don’t consider how taxes will affect their retirement income. As a result, they may end up paying much more in taxes than they would have if they’d known what to expect and planned better.

3 Tax Treatments

A key to managing taxes in retirement is understanding the tax treatment of different types of investment accounts. From a tax perspective, there are three primary types of accounts:

1. Taxable accounts. These consist mainly of brokerage accounts. Taxes are due on investment gains during the year when investments are sold. If investments are held for less than one year, gains are taxed at the seller’s ordinary income tax rate. If investments are held for one year or longer, they are taxed at favorable capital gains rates of 0%, 15% or 20%, depending on the seller’s adjusted gross income.

2. Tax-deferred accounts. These accounts include traditional IRAs and 401(k)s. Taxes aren’t paid until funds are withdrawn in retirement, at which time withdrawals are taxed at ordinary income tax rates. Many people’s tax rates are lower in retirement than during their working years.

3. Tax-free accounts. These include Roth IRAs and 401(k)s, which are funded with after-tax dollars. This means taxes have already been paid, so funds are withdrawn tax-free in retirement. Tax-free accounts are usually the most beneficial retirement accounts from a tax standpoint.

If you have money in all three types of accounts, one strategy is to withdraw funds from your taxable accounts first, your tax-deferred accounts second and your tax-free accounts last. This will give your tax-deferred funds longer to potentially appreciate. Or you could withdraw money proportionally from all of the accounts, which would stabilize your tax bill over the course of retirement.

Required Minimum Distributions

When you turn a certain age, you must start taking required minimum distributions (RMDs) from tax-deferred accounts and pay income taxes on these withdrawals. Distributions must begin by April 1 of the year following the year you turn the required age and, for subsequent years, they must be made by December 31. Failure to take RMDs may result in a steep penalty of 50% of the amount that should have been withdrawn.

So, what is the required age? Before 2019, the answer to this question was relatively simple: the year you turned 70½. However, the Setting Every Community Up for Retirement Enhancement (SECURE) Act raised the required age to 72. Then under SECURE 2.0, enacted in 2022, the required age became subject to when you were born. That is:

• Those born between July 1, 1949, and December 31, 1950, should have begun taking distributions at age 72,
• Those born between January 1, 1951, and December 31, 1956, must begin taking distributions at age 73,
• Those born between January 1, 1957, and December 31, 1959, must begin taking distributions at age 74, and
• Those born on January 1, 1960, or thereafter must begin taking distributions at age 75.

The RMD is calculated based on the balance in your tax-deferred account on December 31 of the previous year. This is then divided by the applicable distribution period or a life expectancy factor based on your age. IRS Publication 590-B, “Distributions from Individual Retirement Arrangements (IRAs),” includes life expectancy tables you can use for this calculation.

RMDs can be minimized, and potentially avoided, by converting a traditional IRA or 401(k) to a Roth account. However, income taxes must be paid on the full value of the account at the time of the conversion, which might not be feasible. Note that if you’re already subject to an RMD, you can’t avoid the one for the current year by making the conversion.

Taxes on Social Security Income

If you continue to earn income after you retire, you might have to pay federal income tax on a percentage of your Social Security retirement benefits. To determine whether your Social Security is taxable, add any nontaxable interest you earn to your taxable income and half of your Social Security benefit to arrive at your provisional income.

If your provisional income is between $25,000 and $34,000 a year as a single person, or between $32,000 and $44,000 a year as a married couple filing jointly, up to 50% of your Social Security benefits will be taxable at your ordinary income tax rate. If your provisional income is more than $34,000 a year, or above $44,000 a year as a married couple filing jointly, up to 85% of your Social Security benefits will be taxable.

Taxes can be withheld from your Social Security benefits by filing IRS Form W-4V, “Voluntary Withholding Request.” You’ll choose a withholding percentage of 7%, 10%, 12% or 22%, not a dollar amount. Or you can make quarterly estimated tax payments to avoid a big tax bill — and possible tax penalty — when you file your return.

Avoid the Wrench

Don’t let taxes throw a wrench into your carefully crafted retirement plans. Take steps now to anticipate the impact of taxes on your nest egg.

Copyright 2024

This article appeared in Walz Group’s March 11, 2024 issue of The Bottom Line e-newsletter, produced by TopLine Content Marketing. This content is for informational purposes only.