How Much Tax Will You Pay in Retirement? Retirement Question No. 5
Stepping into retirement can often symbolize a welcomed shift from working years to a time of rest, relaxation, and reaping the benefits of a life of sacrifice. However, an aspect of this new chapter that many retirees may find surprising is the persistent presence of taxes. It’s a common misconception that one’s tax obligations will decrease significantly during retirement due to lower income. However, the reality is often quite the opposite. Many retirees may find themselves facing higher tax liabilities. Most notably, the growth of investments within taxable retirement accounts can create more tax liabilities than anticipated. Hence, understanding the tax landscape of your retirement income sources and their specific rules is an integral part of your retirement planning. The five most common types of retirement income — Social Security benefits, IRA and 401(k) withdrawals, pension income, investment income, and annuity distributions — all have unique tax rules:
4. ANNUITY DISTRIBUTIONS: The tax rules for annuity payments vary based on whether your annuity was purchased with after-tax dollars. A part of each payment is considered a return of principal, and a part is considered interest. Only the interest portion is included in your taxable income and is taxed as ordinary income. Note: if your annuity is an IRA, all income is taxed as an IRA. 5. INVESTMENT INCOME: Even in retirement, you’ll still owe taxes on dividends, interest income, and capital gains. If you’re selling investments to generate retirement income, each sale will produce a long- or short-term capital gain or loss, which must be reported on your tax return. Another important consideration when planning for retirement taxes is your Medicare premiums. High-income retirees may face the income- related monthly adjustment amount (IRMAA). This surcharge increases Medicare Part B and Part D premiums if your modified adjusted gross income (MAGI) exceeds a certain threshold. Strategic income management in retirement can help you minimize or avoid the IRMAA surcharge.
1. SOCIAL SECURITY INCOME: If Social Security is your sole source of income, you likely won’t owe any taxes in retirement. However,
up to 85% of your Social Security benefits could be taxable if you have additional income. The more non-Social Security income you have, the greater the taxable portion of your benefits. State income tax will vary. In Illinois, Social Security Income is considered non-taxable.
In order to gauge your ongoing tax obligations in retirement, you need to establish a detailed overview of all your potential income sources, calculating how much of each will be taxable annually. But don’t stop at year one; project these calculations forward, considering the potential growth of your income sources, inflation, and the impact of required minimum distributions (RMDs) from certain accounts, starting at age 73 to 75, depending on the year you were born. Navigating this financial maze doesn’t have to be a solo mission. Financial planners with a specialization in tax planning can provide valuable assistance. They can help you strategically plan to minimize taxes,
2. IRA AND 401(K) WITHDRAWALS:
Withdrawals from tax- deferred retirement accounts
like traditional IRAs and 401(k)s are considered ordinary income and taxed accordingly. The amount of tax owed depends on your total income,
deductions, and tax bracket. However, state taxes vary — for example, in Illinois, such income is not subject to state tax. On the other hand, Roth IRA withdrawals are generally income tax-free, as taxes are paid on contributions upfront. 3. PENSION INCOME: Receiving payments from private and government pensions in retirement often comes with a tax obligation. These payments are generally fully taxable at your ordinary income tax rates, assuming no after-tax contributions were made to the pension plan. However, state taxes vary — again, like 401k and IRA income, in Illinois, such income is not subject to state tax.
advise on the optimal timing for withdrawals, assist in potential Roth conversions, guide you toward tax-efficient investments, and help manage possible IRMAA surcharges. Being proactive with your tax planning can have significant benefits. It can help you maintain your net retirement income, reduce the tax impact of RMDs, and decrease future tax liabilities for your heirs. By understanding and preparing for taxes in retirement, you’re taking an essential step towards securing a financially stable and enjoyable retirement. The complexities of the tax landscape in your retirement years may seem daunting, but with careful planning and expert guidance, you can navigate them effectively.
2 McBeathFinancialGroup.com
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