If you're retired or close to retirement, it may come as a surprise to discover that your tax obligations don't disappear just because your paychecks stop coming in. Depending on your income sources in your later years, you may still owe a hefty amount to the IRS.
Planning for this is crucial to ensure your tax bills don't eat into your limited income and make affording the basics impossible. To confirm you're prepared for what you'll have to pay, here are three tax rules every retiree must know.
1. When Social Security becomes taxable
If Social Security is likely to be your major income source, you'll want to know when and if these benefits are taxed.
Both the federal and state governments may take a piece of your retirement benefit checks depending on where you live and how much you earn. Here's how the rules work:
- Up to 50% of your benefits are subject to IRS tax once your provisional income hits $25,000 as a single filer or $32,000 as a married joint filer. Provisional income is one-half of your Social Security plus all taxable and some non-taxable income.
- Up to 85% of benefits are taxed by the federal government once your provisional income hits $34,000 for single filers or $44,000 for married joint filers.
- If you live in one of 13 states that tax benefits, your state government could also take part of your checks. These states include Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, and West Virginia. Income thresholds apply, and these vary by state.
2. How traditional vs. Roth accounts are taxed
Distributions from retirement accounts are another major income source for retirees. But tax rules vary depending on the type of retirement plan you have:
- If you have a traditional IRA or 401(k), you're taxed on account distributions at your ordinary income tax rate. Distributions also count as taxable income for purposes of determining if Social Security is taxed.
- If you have a Roth IRA or Roth 401(k), distributions are tax free and don't count for purposes of determining if you'll be taxed on benefits.
If you expect your tax rate will be higher as a retiree than when you're working, a Roth is likely a better option. If the reverse is true, and you think your rate will be lower, a traditional account could provide more tax savings in the long-run.
Once you're near retirement age, a Roth conversion (transferring money from a traditional to a Roth IRA) is likely off the table due to rules that would necessitate delaying withdrawals for at least five years. You could also get hit with a big tax bill if you did a conversion.
As a result, if you have traditional accounts, you'll need to plan for the taxes you'll owe as you determine the income your accounts will produce.
3. Required minimum distribution rules
Once you reach age 72, you must begin making required minimum distributions (RMDs) if you have a traditional account or a Roth 401(k). These are withdrawals from your tax-advantaged retirement account. The IRS has tables specifying the necessary amount of money to take out. Roth IRAs are exempt from RMD requirements.
If you don't take your RMDs, the tax penalty equals 50% of the amount that should've been withdrawn. So it's crucial you comply with these rules as a retiree.
By learning how Social Security and retirement benefits are taxed, you can develop a tax strategy early on in life. Then, as you approach your later years, you'll hopefully have a realistic idea of the after-tax income available to cover the basics.