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This Expense in Retirement May Catch You Off Guard

By Catherine Brock – Feb 21, 2020 at 6:01AM

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Sadly, you'll have to learn a few new tricks to budget effectively in retirement.

You've spent decades grappling with your budget and learning the costs of your lifestyle. And guess what? You get to toss much of that knowledge aside and learn a new set of expenses once you retire. Budgeting in retirement is a whole new ballgame, and there's one expense that's likely to trip you up: taxes.

Taxes are tricky for retirees. If you've earned regular wages your whole life, you're used to automatic withholdings from your paycheck and an annual true-up of your tax bill. But once you leave the workforce, that hands-off approach to taxes could result in unnecessary penalties. Here's why: Most sources of retirement income are taxable, but those sources may not be withholding taxes on your behalf. That can be a shocker on two fronts. One, the IRS will assess an underpayment penalty, which is never ideal. And two, you'll have to rework your budget to set aside the money to pay Uncle Sam going forward.

Older couple having fun outside

Image source: Getty Images.

Head off both problems by understanding your potential tax liability in retirement, and then budgeting accordingly. Read on to learn how six common sources of retirement income get taxed.

1. Social Security benefits

Each month, tens of thousands of people ask search engines if Social Security is taxable. While Google isn't the best stand-in for a CPA, the answer to this question is pretty straightforward. Up to 85% of your Social Security benefits are taxable, unless you make less than $25,000 in combined income as a single filer or $32,000 as a married filer. Combined income equals adjusted gross income plus non-taxable interest and half of your Social Security benefits.

Social Security will withhold taxes from your benefit check if you request it using Form W-4V. You have the option to withhold at 7%, 10%, 12%, or 22%.

2. Roth and traditional IRA distributions

Roth IRA retirement distributions are tax-free, while traditional IRA retirement distributions are taxed as ordinary income. Once you reach age 59 and a half, you are eligible for penalty-free withdrawals. At that point, it's handy to have balances in both account types. You could choose between tax-free or taxable distributions -- or some combination of both -- to manage your tax liability.

For traditional IRAs, unfortunately, that freedom doesn't last forever. Once you reach age 72, the IRS forces your hand with required minimum distributions or RMDs. These are mandated, taxable distributions you must take from your traditional IRA. The RMD is the IRS' way of asking you to pay up on the taxes you deferred for years in your retirement account. You don't want to ignore RMDs, because the penalties are severe. You'll be assessed 50% of any withdrawal shortfall.

You can request tax withholding from your traditional IRA distributions. Check with the financial institution that manages your account. 

3. 401(k) retirement distributions

From a tax perspective, 401(k)s are similar to traditional IRAs. Distributions are taxed as income and you will have to take required minimum distributions starting at age 72.

RMDs for IRAs and 401(k)s are calculated from your account balances. A higher account balance equals a higher RMD, and a higher RMD means a higher tax bill. It's possible that your RMDs could even push you into a higher tax bracket. You could manage that proactively by taking higher distributions from your taxable accounts between the ages of 59 and a half and 72. You're better off taking more from your 401(k) in that time period, and then delaying your Social Security claim until age 70. That strategy would increase your Social Security benefit and lower your RMDs. Since you only get taxed on 85% of your Social Security benefit at most, that's a good trade-off.

With respect to withholdings, your 401(k) distributions should be treated like wages. You fill out Form W-4P and the payer withholds taxes accordingly.

4. Health Savings Account (HSA) distributions

Distributions from your HSA for qualified medical expenses are tax-free. You stand to save a lot with that perk, considering some estimates predict that retired couples will spend nearly $300,000 out of pocket on healthcare. After age 65, you can use your HSA funds for non-healthcare expenses, too. Those non-medical distributions are taxed as normal income, like your traditional IRA and 401(k) withdrawals.

5. Taxable brokerage account

If you're holding investments in a taxable brokerage account, you pay taxes every year on interest, dividends, and realized capital gains. Nothing about that changes in retirement. The usual practice is to pay the taxes out of your earnings. Say you earn $10,000 in interest and dividends in a given year and, as a result, you owe $2,500 in taxes. You'd pull the $2,500 out to pay Uncle Sam and then reinvest or withdraw the remaining $7,500.

Plan on paying your estimated tax bill during the tax year by way of quarterly tax payments. Otherwise, you might be slapped with an underpayment penalty.

6. Self-employment income

If you set out to earn some extra cash in retirement, you'll owe both income taxes and self-employment tax on your side hustle profits over $400. Self-employment tax consists of Social Security and Medicare taxes and is taxed at 15.3% of your net earnings. As with taxable investment earnings, you should cover these taxes during the tax year by making quarterly tax payments.

Budget your taxes

Estimating your taxes in retirement helps you manage your cash flow and, hopefully, prevents you from fielding an underpayment penalty from the IRS. You can also start making decisions now to address your future tax liability when those dreaded RMDs kick in. All that budgeting and planning ahead may not sound very exciting, but both are key to winning in retirement.

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