Taxes Lower in Retirement? Don’t Plan On It.

taxes

Many people are under the assumption that when they no longer earn the wage they made during their working years they will automatically fall into tax-free bliss during retirement.  The fact is; nothing could be farther from the truth.  Taxes will impact your retirement and must be considered when planning your retirement. In this post, I’ll discuss various forms of taxation, including the taxation of your social security and the impact of IRA distributions during retirement.

Overview

While working you may have found yourself in a higher income tax bracket.  You possibly had two household incomes, a few deductions here and there; maybe your home was paid off so the interest deductions were minimal.  But as you neared retirement you were looking forward to the day that your tax bill would be lower… because after all; social security is tax free.  Isn’t it?  And your income won’t be that high anyway…right?

Good planning requires you think this through very carefully.  Social security benefits are subject to a test to determine if they will be taxable and to what extent.  Distributions from your IRA will also be taxable along with all the usual suspects like interest, dividends, etc.  Many people are entitled to a pension, which is taxable, as well as income from rentals and other investments.  This list is, by no means, exhaustive.

Let’s talk about Social Security.

Franklin D. Roosevelt pounded his fist on the table three times.  “Social Security shall never, never, never be taxed in the hands of the recipient”, he stated emphatically.  But pressure on the social security trust funds eventually forced the hand of congress to renege on that Presidential promise.

Social Security income is not tax free, although part of it may be.  To determine that amount you will complete a worksheet which calculates a modified adjusted gross income (MAGI) to see if you’ve crossed certain thresholds.  MAGI includes ½ of your total Social Security benefits and generally all other reportable income. Below is a table that describes the thresholds based on your filing status.

Filing Status
Up to 50% Included on Return
Up to 85% Included on Return
Single
$25,000
$34,000
Married Filing Joint
$34,000
$44,000

Planning Tip:  Make sure you’re not receiving excess interest income or dividend income that you could otherwise park in a tax-deferred status.  This will minimize your overall income which is part of the social security test and potentially help you stay below the thresholds.  A good retirement planner should be able to help you get pointed in the right direction. Then your CPA or tax advisor can take it from there.

IRA and Qualified Plan Distributions

Any pre-tax distribution from your Qualified Savings Plans will be included in your income.  You can postpone your withdrawals, but eventually you will be required to take distributions.  These are known as Required Minimum Distributions (RMD) and are mandatory beginning April 1st, the year after you turn 70-1/2.

The logic is that you’ve been postponing taxes on the contribution and gains for long enough.  Now it’s time to pay some of that deferral back.

The IRS provides a table which you will use to calculate the amount of the distribution and that amount will go on your tax return as ordinary income.  It cannot be rolled over.  It cannot be converted to a Roth.  It is time to pay the tax man.

Knowing this in advance, you may want to consider taking some distributions earlier…not waiting until 70-1/2.  Rather, start taking distributions as soon as you are eligible (after 59 ½) to manage the growth of your Qualified Savings and spread the taxes out over a longer period of time.  During the earlier years you control how much you’ll distribute.  However, after your Required Beginning Date, the formula is set and must be adhered to.

What you should do next?

Let’s face it.  Taxes are here to stay and the rates are likely to go up over time.  Just because you are retired doesn’t mean there is reprieve from taxation or that you will automatically be in a lower tax bracket.

In fact, you must think this through very carefully with your retirement planner and develop a specific plan of action tailored to your situation.  Of course, this discussion is by no means exhaustive of all the ways that a retiree can be taxed or the planning methods that can address excess taxation.  However, with good planning the savings opportunities can be found.  Remember: a dollar of taxes saved is one more dollar toward your financial freedom.

(Disclaimer:  Randy Becker is not a CPA or Tax Advisor.  In writing this article, Mr. Becker intends to give the reader general concepts only and is not recommending any specific strategy to any specific individual.  Readers are encouraged to talk directly with their CPA or Attorney for specific advice related to Income Tax matters)