Even in retirement, you likely won't be able to escape Uncle Sam taking a chunk of your earnings. If you're not preparing for taxes in retirement, your savings likely won't go as far as you think they will. You may owe thousands of dollars in taxes each year, depending on what your retirement income looks like, and a hefty tax bill can make it harder to enjoy your senior years comfortably.
Fortunately, a little planning can go a long way. By understanding how taxes will affect your retirement income, you can prepare for them ahead of time to ensure you'll still have enough money to make ends meet. As you're saving for the future, consider these three ways taxes could affect your income during retirement.
1. You may face taxes on your retirement fund withdrawals
If you've stashed money in a 401(k) or traditional IRA, you'll owe income taxes on those withdrawals in retirement. The only way to avoid paying taxes on retirement account withdrawals is to invest in a Roth IRA. With a 401(k) or traditional IRA, your contributions are tax-deductible upfront. But with a Roth IRA, you'll pay taxes when you make the initial contributions -- so your withdrawals will be tax-free.
Some workers may have savings in multiple types of accounts. In that case, it's important to come up with a withdrawal strategy to minimize your tax bill in retirement.
For example, if there are years of retirement when you know you'll be spending a lot more money -- like if you have several expensive vacations planned or want to renovate your home -- it's a good idea to withdraw more of your income from your Roth IRA because that money will be tax-free. Then, during the years when you're spending less, you can withdraw more from your traditional IRA or 401(k).
If you want to minimize your taxes in retirement, you may choose to invest primarily in a Roth IRA now so the bulk of your savings will be in this type of account. Although you'll owe taxes upfront, if you're currently in a lower tax bracket than you expect to be when you retire, saving in a Roth IRA could help you pay less in taxes than if you save in a 401(k) or traditional IRA.
2. You could pay taxes on Social Security benefits
The unfortunate truth is that even though you've been paying Social Security taxes for decades, you may also owe taxes on your monthly checks once you retire.
You could face both state and federal taxes on your benefits. Whether you owe state taxes will depend on where you live, because although the majority of states do not tax benefits at the state level, there are 13 that still do. (Also, while West Virginia currently taxes benefits, the state is planning to phase this tax out by 2022.)
When it comes to federal taxes, how much you're taxed will depend on what's called your "combined income" -- which is half your annual Social Security benefit amount plus all other sources of income. (However, Roth IRA withdrawals do not count toward your combined income.) Depending on your yearly income, you could face income taxes on up to 85% of your Social Security benefits:
|Percentage of Your Benefits Taxed
|Combined Income for Individuals
|Combined Income for Married Couples Filing Jointly
|Less than $25,000 per year
|Less than $32,000 per year
|Up to 50%
|$25,000 to $34,000 per year
|$32,000 to $44,000 per year
|Up to 85%
|More than $34,000 per year
|More than $44,000 per year
The only way to avoid Social Security taxes entirely is to make sure you're living in a state that doesn't tax benefits, and then keep your combined income below $25,000 (or $32,000 for married couples) per year. If you have a Roth IRA, that's an advantage because those withdrawals don't count toward your combined income -- so you can spend more each year while potentially lowering your federal tax bill.
3. You could face expensive RMD penalties
Required minimum distributions (RMDs) are traditional IRA or 401(k) withdrawals you must make once you turn age 72. The reasoning behind RMDs is that because traditional IRA and 401(k) contributions are tax-deferred, you don't pay taxes on that money until you make withdrawals. Eventually, Uncle Sam will want his cut, so you can't leave your cash in these accounts forever.
Not taking your RMDs can result in a hefty penalty, too. If you don't withdraw the full amount from your 401(k) or traditional IRA that you're supposed to, you'll face a 50% tax on the amount you didn't withdraw. For instance, if you have an RMD of $20,000 and you don't withdraw anything that year, you'll be hit with a $10,000 tax. Or if you only withdrew $15,000 when you should have withdrawn $20,000, you'll face a tax of $2,500.
Taxes can potentially take a big bite out of your retirement income, so it's vital to prepare for them as much as possible. By being aware of what taxes you may owe and coming up with a strategy to minimize them the best you can, you'll be able to stretch every dollar in retirement.