While it's true that retirees get to reap certain benefits that younger Americans don't -- think Medicare, Social Security, and a host of senior-citizen discounts -- when it comes to paying taxes, older Americans are by no means immune. Though it may come as a shock to many seniors, there are several common forms of retirement income that are subject to taxes.
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Investment gains
Just as you paid taxes on investment gains back when you were working, so too will you pay taxes on the gains your non-qualified investments generate in retirement. Short-term capital gains -- those that apply to assets held for one year or less -- are taxed as ordinary income, while long-term capital gains -- those that apply to assets held for more than a year -- are taxed at a maximum of 20%. However, that 20% rate really only applies to the wealthiest Americans. Most taxpayers are only taxed 15% for long-term capital gains, and if you're in a low enough tax bracket, you might not pay any taxes at all on your long-term gains.
While you may not succeed in avoiding taxes entirely on your investment gains, there are steps you can take to soften the blow. First, try to hold off on selling assets at a gain until you've held them for more than a year. This way, you'll bump them into the long-term gains category and pay less tax on your profits. Secondly, you might consider shifting some of your investments into tax-free alternatives. Municipal bonds, for example, are always exempt from federal taxes, and if you buy bonds issued by your home state, they're free of state and local taxes as well.
Retirement account withdrawals
Many retirees rely on their personal savings to pay a large portion of their living expenses once they're no longer working. But even if you've managed to avoid dipping into your savings thus far, once you reach age 70 1/2, you're actually required to start taking minimum distributions from your retirement accounts (unless you have a Roth IRA, in which case you can leave the money in there as long as you'd like). But here's the kicker: The withdrawals you take from your 401(k) or IRA are not only subject to taxes, but taxed as ordinary income. The same goes for pension plan withdrawals.
Now if you have an annuity that you purchased with after-tax dollars, the portion of your withdrawal that represents your principal is tax-free. Your gains, however, are subject to taxes.
If you happen to have a Roth IRA, there's some good news: Because you already paid taxes on the money that went into that account, you won't have to pay taxes when you take withdrawals in retirement. There's a small catch, however: Your Roth needs to have been open for at least five years before you start taking out money.
Social Security
Believe it or not, that Social Security check you get every month could be subject to taxes. While some people don't have to pay taxes on Social Security, those with additional sources of income are often surprised to learn that some of their benefits are indeed taxable. To figure out if you'll need to pay taxes on your Social Security benefits, you'll need to calculate what's known as your provisional income.
First, you'll need to take your gross income (your total income outside of Social Security) plus whatever tax-free interest you receive (like the type you'd earn from municipal bonds) plus 50% of your Social Security benefits. If that number is between $25,000 and $34,000 and you're a single filer, or between $32,000 and $44,000 and you're a joint filer, then you could be taxed on up to 50% of your benefits. Furthermore, if your provisional income is above $34,000 as a single filer or $44,000 as a joint filer, you could be taxed on up to 85% of your benefits.
Nobody likes paying taxes, and when you're living on a fixed income, an expected tax bill could be a major burden. Knowing what to expect tax-wise can help you prepare accordingly and avoid getting caught off guard.
