Retirement planning is difficult enough, but taxes can make it an even greater challenge. Taxes don't go away once you retire, and if you're not preparing for them, they could wreak havoc on your retirement plans.
The good news is that by understanding these key tax rules, you can avoid any unpleasant financial surprises in retirement.
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1. Income taxes on Social Security
Even though you've been paying into the Social Security program for decades, you may owe taxes on your benefits themselves once you retire.
Your monthly checks may be subject to both state and federal income taxes. State taxes will depend on where you live, and fortunately, there are only 13 states that do tax benefits. Federal taxes, though, depend on your income in retirement.
Whether or not you'll owe federal taxes on your Social Security benefits will depend on your "provisional income" -- which is your adjusted gross income, plus half your annual benefit amount, plus any nontaxable interest. If your provisional income is higher than $25,000 per year (for individuals) or $32,000 per year (for married couples filing jointly), up to 85% of your benefit amount will be subject to income taxes.
2. Income taxes on retirement fund withdrawals
If you're saving in a tax-deferred account such as a 401(k) or traditional IRA, you haven't paid taxes on any of your retirement contributions so far. That means once you retire and start making withdrawals, you'll owe income taxes on your distributions.
Even if you're already aware that you'll need to pay taxes, it's a good idea to estimate approximately how much you'll owe each year and factor that into your retirement budget. Income taxes can take a larger bite out of your savings than you may expect, and if you underestimate your tax bill, your savings may not go as far as you need them to.
3. Required minimum distributions
Not only will you owe income taxes on 401(k) and traditional IRA withdrawals, but you also need to withdraw a certain amount each year. These withdrawals are called required minimum distributions, or RMDs.
You're required to start taking RMDs once you turn 72 years old, and the size of your RMD will depend on your age as well as how much money you have in your retirement accounts. If you don't take your RMD, you'll face a hefty tax penalty: 50% of the amount you were supposed to withdraw. So, for instance, if you have an annual RMD of $30,000 and you skip it entirely, you'll be slammed with a $15,000 tax penalty.
How to avoid taxes in retirement
One of the best ways to avoid all three of these tax burdens is to invest in a Roth IRA. With a Roth IRA, you'll pay income taxes on your initial contributions, but not your withdrawals. Roth IRAs are also not subject to RMDs within the account owner's lifetime, so that's another factor you won't need to worry about.
Finally, a Roth IRA can also help you reduce or eliminate your Social Security taxes. Roth IRA withdrawals are not included in your provisional income. That means if most of your savings are in this type of account, you can reduce your provisional income enough that you can avoid taxes on your benefits.
Taxes can be a headache, but it can be difficult to avoid them entirely. By planning for them now, though, it can help take the sting out of taxes in retirement.
