Income taxes can be as persistent as weeds, making them challenging to manage.
While retirement often brings significant changes to your financial landscape, you won’t be able to avoid taxes entirely if you have income from a job, pension, investments, or Social Security. Ironically, owing taxes often indicates a higher income, suggesting greater financial stability. Fortunately, there are several tax breaks available after retirement that can help ease the burden.
Once you retire, you no longer pay Social Security and Medicare taxes, which can significantly boost your bottom line by several thousand dollars. Additionally, if you earn a pension in one state and later move to another, you won’t owe taxes on that pension income to the state where it was earned, although you’ll still be subject to taxes in your new state of residence. Upon reaching age 65, you may also qualify for a larger standard deduction when filing your federal tax return, further enhancing your financial situation.
Taxing rules
Most retirement income is subject to taxation, depending on the type of income. Here’s a summary of the federal rules that apply:
- Annuity Income: Each annuity payment consists of a portion classified as a return of principal, which is not taxed unless it was purchased with pretax dollars. The earnings portion is taxed at your regular income tax rate.
- Capital Gains: Profits from selling stocks, mutual funds, your home, and other equity investments are taxed at the long-term capital gains rate, provided you held the investments for the required duration.
- Interest Income: Taxed at your regular income tax rate. Dividends from qualifying stocks and mutual fund distributions are taxed at the long-term capital gains rate.
- IRA Distributions: Earnings in a traditional IRA and contributions for which you took a tax deduction are taxed at your regular income rate upon withdrawal. Withdrawals of nondeductible contributions are not subject to tax. For a Roth IRA, distributions are tax-free if you are at least 59½ and the account has been open for at least five years.
- Lump Sum Distributions: Withdrawals from pensions, 401(k)s, and other salary-reduction plans are taxed at your regular income tax rate.
- Pension Annuity Income: Taxed at your regular income tax rate.
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Rollovers: Transfers from pensions, 401(k)s, and other salary-reduction plans remain tax-deferred until withdrawals are made.
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Brackets and rates
The amount of tax you owe on your regular income is determined by your filing status, the specific rates at which different levels and types of income are taxed, and the tax bracket you fall into.
A tax rate represents the percentage of tax applied to a specific level of income. In the U.S., there are seven tax rates, and you pay the lowest rate on a base amount of income, with progressively higher rates applied as your income exceeds certain thresholds, known as tax brackets. These brackets are adjusted annually to account for inflation.
For instance, if your taxable income spans three brackets, you would pay tax at the 10% rate on income within the lowest bracket, 15% on income in the next bracket, and 25% on any income that exceeds the higher bracket.
Your marginal tax rate is the highest rate applied to any portion of your taxable income. Using the example above, if your income places you in the 25% bracket, that would be your marginal tax rate. Many individuals anticipate being in a lower tax bracket in retirement, as they expect their taxable income to decrease.
Don’t forget about estate taxes
As income tax rates have risen, so too has the amount exempt from federal estate tax. This development is especially encouraging for those with significant wealth, as estate taxes are assessed based on the value of assets that exceed the exempt threshold at the time of your passing.
Although the exempt amount may fluctuate and future laws remain uncertain, a thoughtfully crafted estate plan can help you maximize what you leave to your heirs. It’s advisable to consult with an experienced professional to ensure that your estate plan aligns with your goals and provides the most generous support for your loved ones.
Extra taxes
While it’s possible to navigate around tax penalties, responsibility lies with you to ensure compliance with regulations. If you withdraw from retirement plans before reaching age 59½, you may incur a 10% penalty in addition to any income taxes owed.
However, certain exceptions allow penalty-free withdrawals from IRAs for specific expenses, such as paying for medical bills, funding higher education, or up to $10,000 to purchase your first home. Additionally, you may be able to borrow from some retirement plans without penalty, provided you repay the amount within five years. Failure to repay can result in both the 10% penalty and the applicable taxes.
Once you turn 70½, you are required to take minimum distributions from your traditional IRA; failing to do so incurs a 50% penalty on the amount you should have withdrawn. Furthermore, there’s a 6% annual penalty for excess contributions to your IRA, including any contributions made in the year you turn 70½.
If you opt for an indirect rollover from a qualified plan, be aware that 20% will be withheld for taxes. To reclaim this amount when filing your income tax return, you must deposit the total distribution (including the withheld 20%) into an IRA. If you fail to do so—regardless of the reason—the withheld 20% is treated as a withdrawal, subject to income tax and potentially the 10% early withdrawal penalty. To sidestep these complications, consider a direct rollover instead.
Some income is tax free
Just as you can strategically choose how to take income to minimize your tax burden, you can also explore tax-exempt investments to avoid taxes altogether, although be mindful of the potential impact of the alternative minimum tax (AMT).
For instance, interest earned on certain municipal bonds issued by state and local governments is exempt from federal tax (and state tax if you reside in the state of issuance). Similarly, interest from U.S. Treasury bonds, notes, and bills is free from state and local taxes. Additionally, if you wait until after age 59½ to withdraw funds from a Roth IRA, and your account has been open for at least five years, you won’t owe any income tax on those withdrawals.
While it may be challenging to generate all the income you need solely from these sources—due to contribution limits on Roth IRAs and the inflationary risk on interest income—these options can significantly enhance your overall income by eliminating tax liabilities.
Wishing you a great week!
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