Taxes in Retirement - How Much Will You Pay?

7 answers to taxes in retirement - how much you pay on what

Older man talking taxes with young accountant
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You will continue to pay taxes in retirement. Taxes are calculated on your income each year as you receive it, much like how it worked before you retired.

How much in retirement taxes will you pay? Without knowing your situation, that's a difficult question to answer. Each type of income you receive will have different tax rules that apply to it. To help you figure it out, below I've listed the seven types of income you are most likely to receive in retirement, and how each is taxed.

1. Will I pay tax on Social Security income?

If your only source of retirement income is Social Security then most likely you will pay no taxes in retirement. For those of you with other sources of income a portion of your Social Security income is likely to be taxed. The amount of tax is determined by a formula. The result of the formula is that you may have to include up to 85% of the Social Security benefits you receive as taxable income on your tax return.

The amount that is taxable (anywhere from zero to eighty-five percent) depends on how much other income you have in addition to Social Security. The IRS calls this other income "combined income" and in the tax worksheet you plug your combined income into a formula to determine how much of your benefits will be taxable each year.

Retirees with a high amount of monthly pension income will likely pay taxes on 85% of their Social Security benefits and their total tax rate may run anywhere from 15% to as high as 45%.

Retirees with almost no income besides Social Security will likely receive their benefits tax-free and pay no income taxes in retirement.

2. How much of my retirement income will be taxable?

The amount of taxes you pay in retirement will depend on your total amount of income and deductions. Not every source of cash flow is income.

For example, assume you own a bank CD. The CD matures in the amount of $10,000. That $10,000 is not extra taxable income to be reported on your tax return - only the interest it earned is reported. But the entire $10,000 is available as cash flow you can use to cover expenses.

There are tax-free sources of income (such as municipal bonds), and taxable sources of income (such as IRA withdrawals) so the amount of your retirement income subject to taxation will vary depending entirely on the source of the income. There are certainly ways to structure your retirement income so that you pay less taxes in retirement - it will take research on your part or the assistance of a professional retirement planner.

3. How are IRA and 401(k) withdrawals taxed?

Most withdrawals from retirement accounts are taxed in retirement. This means IRA withdrawals are reported on your tax return as a source of taxable income, as well as withdrawals from 401(k) plans, 403(b) plans, 457 plans, etc.  Most people will pay some tax when they withdraw money from their IRA or other retirement plans.

 

The amount of tax you pay depends on the total amount of income and deductions you have and what tax bracket you are in for that year. For example, if you have a year with more deductions than income (such as a year with a large amount of medical expenses), then you may not pay tax on withdrawals for that year.  

There is one type of retirement account where withdrawals are usually tax-free. If done correctly, you will pay no retirement taxes on Roth IRA withdrawals

4. Are pensions taxable?

Most pension income will be taxable. The easiest way to determine the likelihood that your pension income will be taxed is to use a simple guideline: if it went in before tax, when you withdraw it, it will be taxed. Most pensions accounts were funded with pre-tax income which means the entire amount of your annual pension income would be included in your taxable income each year. In this case you can ask that taxes be withheld directly from your pension check.

If a portion of your pension account was funded with after-tax dollars then each year a portion of your pension income will be taxable and a portion will not.

5. Is annuity income taxable?

If your annuity is owned by an IRA or other retirement account, then the tax rules in the section above will apply to any withdrawals or annuity payments you receive from that annuity.

If your annuity was purchased with after-tax dollars (meaning not purchased within an IRA or other retirement account) then the tax rules that apply depend on what type of annuity you purchased. 

  • Income from an immediate annuity - A portion of each payment you receive from an immediate annuity is considered a return of principal and a portion is considered interest. Only the interest portion will be included in your taxable income. Each year the annuity company can tell you what your "exclusion ratio" is, which tells you how much of the annuity income you receive can be excluded from your taxable income.
  • Withdrawals from a fixed or variable annuity - The tax rules on these types of annuities say that earnings must be withdrawn first, which means if your account is worth more than what you contributed to it, when you take withdrawals, initially you will be withdrawing earnings, or investment gain, and it will all be taxable income to you. Once you have withdrawn all your earnings, then you will be withdrawing your original contributions (called your cost basis), and those are not included in your taxable income.

6. What about investment income?

You will pay taxes on any dividends, interest income, or capital gains, just as you did before you were retired. These forms of investment income are reported on a 1099 tax form each year which is sent to you directly from the financial institution that holds your accounts.

If you systematically sell investments to generate retirement income, each sale will generate a long or short term capital gain (or loss) and that gain or loss will be reported on your tax return. If your other income sources are not too high you may qualify for the zero percent capital gains tax rate - which means you would pay no tax on all or a portion of your capital gains for that year.

If you own investments that are not inside of a retirement account you can learn how to manage your capital gains and losses to reduce the taxes that you pay in retirement. 

7. What taxes apply when I sell my home?

If you have lived in your home for at least two years then most likely you will not pay taxes on gain from the sale of your home unless you have gains in excess of $250,000 if single, or $500,000 if married. If you rented your home out for awhile, the rules get more complex and most likely you will need to work with a tax professional to determine how any gains need to be reported. 

The good news: there is one tax you will no longer pay when retired - you will no longer pay payroll tax - unless you go back to work, or are self-employed and have some form of earned income.

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