Wouldn’t you think after giving a portion of your income to Uncle Sam for decades, you would be off the hook once you reach retirement? Unfortunately, that’s not the case. Uncle Sam is going to continue to knock on your door requesting retirement taxes well into your golden years.
Fortunately, you can create a retirement plan that minimizes your taxation once you understand where these taxes may arise. You’ll find that they can impact the entire canvas of your personal finances, including your income, investments, and assets. So, to help you reduce your tax bill in retirement, here are several taxes you should know about.
Social Security tax
In retirement, you’ll need to pay close attention to your Social Security benefits and taxable income. It’s possible that you may have to pay taxes on your benefit amount if your total taxable income reaches a certain limit. Typically, only retirees who have a significant income from sources such as dividend payments, distributions from tax-deferred retirement accounts, or wages face taxation.
If your combined income, i.e., the sum of your income’s tax-exempt interest and half the value of your Social Security benefits, when you file individually is between the range of $25,000 and $34,000, up to 50% of your benefits could be liable for income tax. That percentage increase to 85% if you file over $34,000.
Even when you have a spouse and file jointly, your combined income will still have to pay income taxes on a percentage of your combined income. However, the range for a joint return is $32,000 to $44,000. If you fall within that range, as much as 50% of your benefits will be subject to income tax. Exceeding the upper limit of $44,000 will increase the percentage to 85%, just like the individual tax return.
Required Minimum Distribution (RMD) tax
If you have contributed to a traditional IRA or an employer-sponsored plan such as a 401(k) or 403(b), the IRS requires you to take distributions known as RMDs beginning at age 72. Prior to last year, the distribution age was 70 ½.
During your working years, you are able to deduct your contributions to IRAs and 401(k) accounts. So, when you retire, Uncle Sam is ready to cash in on his fair share of your contributions. To do so, the IRS requires all account holders to distribute the correct amount of money from their account every year. If an account holder fails to do so, they will have to pay a hefty penalty.
To calculate your RMDs, you must divide your account balance by your life expectancy factor, using the IRS Life Expectancy Table. However, if your spouse is the beneficiary of your retirement account and they are ten years younger than you, you’ll use the IRS Joint Life Expectancy Table to determine your RMD amount.
The IRS taxes your RMDs by your ordinary income tax. In other words, RMDs act as income and are subject to federal taxation and state taxation if it applies. It’s important to point out that depending on your RMD amount and other income, your distributions could push you into a higher tax bracket, resulting in more taxes in retirement. So, keep an eye on your taxable income so you can minimize your taxes as much as possible.
Bear in mind that RMDs do not apply to Roth accounts. So, if you have a Roth, you won’t have to worry about taking RMDs from this account.
Pension income tax
If you have a pension, you will have to pay taxes on any distributions you take from your pension payments and tax-deferred annuities or retirement accounts. When you receive payments from your pension, you must pay taxes at your federal income tax bracket rate.
If you decide to take a lump-sum distribution, however, you’ll have to pay taxes on the total amount the year you took the distribution.
Traditional IRA and 401(K) distribution tax
If you want to use your traditional IRA, 401(k), 403(b), or 457 as an income stream, you’ll need to pay taxes on any distribution amount, just like RMDs. For information on how the IRS calculates your distribution taxes, you can visit their website.
If you have a Roth IRA, you won’t have to pay taxes on any of your distributions. Since you have already paid taxes on all contributions during your working years, your withdrawals are tax-free in retirement (rejoice). But, in order to take distributions from a Roth account, the account has to be open for at least five years.
Taxable account tax
The way the IRS applies taxes to taxable accounts is a little different than what you see with retirement accounts. While the principal amount is taxed at your standard rate, your dividends or capital gains are taxed at a capital gains tax rate. The long-term capital gains tax applies to assets you have held onto for over a year.
According to the IRS, most individuals pay 15%. However, some may not have to pay long-term capital gains taxes at all as long as their income is less than $80,000 per year. If you make over $441,450 per year as a single filer and over $496,600 for married filers, a 20% long-term capital gains tax may apply. There are some situations where the capital gains tax is higher than 20%, such as when selling collectibles. For assets you dispose of within less than a year of holding them, your regular tax rate may apply.
Bonus: Estate tax
Many people want to leave a lasting legacy behind to their loved ones. One way to do so is to transfer wealth, which can kill two birds with one stone. Not only does it provide security for your heirs, but it helps you avoid some costly estate taxes. As of 2021, gifts exceeding $11,700,000 ($23.4 million for married couples) are subject to an estate tax.
While this form of taxation may only apply to a small percentage of the country, some states may apply an inheritance tax. For example, Iowa has between a 5% and 15% tax on inheritance, depending on property and asset value.
So, to avoid any looming estate or inheritance taxation taking a big bite out of your estate, you may want to gift some of your assets to your heirs while you’re living. Take a look at the IRS limits on gifting. Keep in mind; they can adjust. You can also open a trust to help shelter your estate from probate.
It’s evident that there’s just one tax after the other waiting after you reach retirement. The rigor of navigating them all on your own can lead to frustration and, ultimately, mistakes if you’re not careful. You don’t have to manage alone, though.
A financial planner understands the ins-and-outs of the system and can work with you to create a plan that will minimize your taxes in retirement. It would mean less stress on your plate and protecting the funds you’ll need. That way, you can focus on what truly matters during your golden years instead of entertaining Uncle Sam.