One common retirement misconception is that your tax burden will be negligible compared to what it was during your working years. But that may not come to be the case. Depending on the income sources you have available to you in retirement, you could face a sizable tax bill year after year as a senior. Here are just some of the ways you might get hit.
1. Traditional IRA or 401(k) withdrawals
Saving in a tax-advantaged plan like an IRA or 401(k) is a smart way to build a nest egg. But while traditional IRAs and 401(k)s offer an immediate tax break for contributing, as well as tax-deferred growth on your money, once you reach retirement, the withdrawals you take are taxed as ordinary income -- meaning at your highest possible rate. The only way to get around those taxes is to save in a Roth IRA or 401(k) or convert your existing savings to a Roth-style account. Go the latter route, however, and you'll be liable for taxes when you make that conversion.
2. Social Security benefits
Seniors who collect Social Security and don't have much other income can often avoid taxes on their benefits. But if you have other income sources, such as savings or a part-time job, there's a good chance your Social Security benefits will be taxed.
To see if this is the case, you'll need to calculate your provisional income, which is your non-Social Security income plus half of your yearly benefits. If your total falls 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 face taxes on up to 50% of your benefits. And 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.
3. Pension income
Though many companies are doing away with pensions, if you happen to have one, consider yourself lucky. But don't make the mistake of thinking that money will be yours free and clear of taxes in retirement. Payments made from pensions -- both of the government and private sector variety -- are generally taxed as ordinary income. However, certain types of military or disability pensions may end up being partially or completely tax-free.
4. Investment gains
Investment gains are taxable in retirement, assuming those assets aren't being held in a qualified retirement account. However, you can ease the burden by holding investments for at least a year and a day before selling them at a price that's higher than what you paid. This way, you'll bump yourself into the long-term capital gains category, which has a far more favorable tax rate than short-term gains, which are taxed as ordinary income. Therefore, it's wise to avoid them when possible.
5. Investment income
Some people make money off their investments by selling them at a profit. Others, however, make money by holding on to their investments and collecting dividend payments on stocks and interest payments on bonds. The bad news? Dividend and interest income is generally subject to taxes. The good news? Qualified dividends are taxed at a more favorable rate, and most dividends tend to fall into this category.
Furthermore, if you invest in municipal bonds (those issued by cities, states, and other localities) instead of corporate bonds, your interest payments will be exempt from federal taxes. And if you buy municipal bonds issued by your home state, you'll avoid state and local taxes, as well.
6. Bank account interest
Many seniors opt to keep at least some money in a savings account, where they don't face the same loss of principal that exists with other types of investments. And even though today's interest rates are far from generous, if you're housing a large sum of cash in the bank, it could impact your tax bill. In fact, bank account interest is taxed as ordinary income, so once again, you're looking at paying your highest possible rate.
This isn't to say that you should unload your savings account. Quite the contrary -- you need an emergency fund in retirement just as you do when you're working. Just be aware of the tax consequences that might ensue.
Nobody wants to pay taxes, especially when you're on a relatively fixed income. But if you prepare for what could lie ahead, you'll be in a better position to withstand that financial blow.