How to Estimate Taxes in Retirement
Don't get caught off guard by your tax bill in retirement
You'll most likely continue to pay taxes in retirement. They're calculated on your income each year as you receive it, much like how it works before you retire. Different tax rules can apply to each type of income you receive. You should know how each income source shows up on your tax return in order to estimate and minimize your taxes in retirement.
The six most common types of retirement income are taxed with varying rules.
Social Security Income
You probably won't pay any taxes in retirement if Social Security benefits are your only source of income, but a portion of your benefits will likely be taxed if you have other sources of income. A formula determines the amount of your Social Security that's taxable. You might have to include up to 85% of your benefits as taxable income on your return.
The taxable amount—anywhere from zero to 85%—depends on how much other income you have in addition to Social Security. The IRS calls this other income "combined income," and you can plug your combined income into a formula in its tax worksheet to determine how much of your benefits will be taxable each year.
Retirees with high amounts of monthly pension income will likely pay taxes on 85% of their Social Security benefits, and their total tax rate might run as high as 37%. Retirees with almost no income other than Social Security will likely receive their benefits tax-free and pay no income taxes in retirement.
IRA and 401(k) Withdrawals
Withdrawals from tax-deferred retirement accounts are taxed at ordinary income rates. This is a long-term asset, but withdrawals aren't taxed at long-term capital gains rates. IRA withdrawals, as well as withdrawals from 401(k) plans, 403(b) plans, and 457 plans, are reported on your tax return as taxable income.
Most people will pay some tax when they withdraw money from their IRA or other retirement plans. The amount of tax depends on the total amount of income and deductions you have and what tax bracket you're in. You might not pay taxes on withdrawals if you have a year with more deductions than income, such as a year with a lot of medical expenses and itemize your deductions to claim them.
Roth IRA withdrawals are typically tax-free because you can't take a tax deduction for your contributions in the year you make them. You've already paid taxes on this money once so you won't have to pay again when you take it back out.
Most pension income is taxable. It will be taxed if you withdraw pre-tax money you contributed to it. Most pension accounts are funded with pre-tax income, which means the entire amount of your annual pension income will be included on your tax return as taxable income each year that you take it. You can ask that taxes be withheld directly from your pension check to offset the hit at tax time.
A portion of your pension income will be taxable each year and a portion will not if a portion of your pension account was funded with after-tax dollars.
Tax rules apply to any withdrawals or annuity payments you receive from an annuity that's owned within an IRA or another retirement account. The exact tax rules will apply depend on whether your annuity was purchased with after-tax dollars—it wasn't purchased within an IRA or another retirement account.
A portion of each payment you receive from an immediate annuity is considered a return of principal, and a portion is considered to be interest. Only the interest portion will be included in your taxable income. The annuity company can tell you what this "exclusion ratio" is each year. It will show you how much of the annuity income you receive can be excluded from your taxable income.
The tax rules on withdrawals from fixed or variable annuities dictate that earnings must be withdrawn first. You'll initially be withdrawing earnings or investment gain if your account is worth more than what you contributed to it, so it will all be taxable. You'll begin withdrawing your original contributions after you've withdrawn all your earnings, and these are not included in your taxable income.
You'll pay taxes on dividends, interest income, or capital gains, just as you did before you retired. These types 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. The IRS receives a copy as well.
Each sale will generate a long- or short-term capital gain or loss if you systematically sell investments to generate retirement income, and this must be reported on your tax return. You would pay no tax on all or a portion of your capital gains for that year if your other income sources aren't too high. You might qualify for the 0% long-term capital gains.
Not every source of cash flow from investments is counted as taxable income. You might own a CD that matures in the amount of $10,000. That $10,000 isn't 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.
Gains Upon the Sale of Your Home
You most likely won't pay taxes on gains from the sale of your home if you've lived there for at least two years, unless you have gains in excess of $250,000 if you're single, or $500,000 if you're married. The rules get more complex if you rented your home out for a while, so you might want to work with a tax professional to determine if and how you should report any gains.
Calculating Your Tax Rate
Your tax rate in retirement will depend on the total amount of your taxable income and your deductions. List each type of income and how much will be taxable to estimate your tax rate. Add that up, then reduce that number by your expected deductions for the year.
For example, let's assume that you're married and filing a joint return with your spouse. You have $20,000 in Social Security income, $25,000 a year in pension income, and you expect to withdraw $15,000 from your IRA. You estimate that you'll have $5,000 a year in long-term capital gains income from mutual fund distributions.
Add up your ordinary income, not including capital gains, using 85% of your Social Security benefits. This works out to $57,000.
Your standard deduction for 2020—the tax return you'll file in 2021—would be $24,800 as a married couple filing jointly. That puts your estimated taxable income at $32,200, placing you in the 12% tax bracket for your top dollars. You'll pay 10% on the first $19,750 of taxable income, and 12% on the income that falls between $19,750 and $80,250.
Your estimated tax bill would therefore be $3,469. Your capital gains will qualify for the 0% rate and won't be taxed because you're in the 0% for long-term capital gains on a taxable income of $32,200. You could have taxes withheld from your IRA distribution, set up quarterly tax payments of $867.25 per quarter, or ask your pension to withhold taxes at about a 20% rate to pay your taxes in a timely manner.