Taxes can take a big bite out of your retirement income. The more retirement income you have, the more you will be taxed. This results in more of you hard earned money being used to pay taxes. Keep reading as I share how various types of retirement income are taxed.
The good news is that most people will pay fewer taxes in retirement than when they were fully employed. Of course, this doesn’t mean seeing your tax bill in retirement won’t be painful every time you have to write a check to the IRS and your state tax authorities.
With some proactive tax planning, you can drastically reduce the taxes you will owe on your retirement income. You might even be able to increase your tax-free retirement income.
Taxes On Social Security Income
Each year about half of Social Security recipients will owe federal income taxes on this portion of their retirement incomes. You will owe taxes on your Social Security benefits when your income exceeds a total income threshold each year. For 2022, this threshold is $25,000 for single filers and $32,000 for joint filers. Fifty percent of your Social Security benefits count as taxable income.
For 2022, Social Security recipients with income above $34,000 single and $44,000 married filing joint, 85% of your Social Security benefits will be taxable. I must also point out that these thresholds are not indexed for inflation, so I expect more of your Social Security benefits will be taxable as time goes on.
Tax-deferred Retirement Income
Think of this as a withdrawal from your IRA, 401(k), 403(b), 457, or Cash Balance Pension Plan. Contributions to these plans were excluded from your taxable income, and the IRS wants to collect taxes once you finally make withdrawals.
Your withdrawals will be taxed at the prevailing tax brackets of the year you make withdrawals. The more retirement income you earn each year, the more taxes you will likely owe. The current top federal tax bracket is 37%. The top state tax bracket, here, in California is 13.3%.
Income From Annuities in Retirement
If you own an annuity, how your income is taxed will depend on how the account is titled. The withdrawal will be taxed as regular income if you own an annuity within your IRA. If you own a Non-Qualified Annuity, you will first withdraw your ” profits, ” which will be taxed as regular income. Once your profits have been depleted, you will be withdrawing your cost basis, which can come out tax-free.
If you own a non-qualified annuity, you should work with your tax-planning financial planner to develop a strategy to make withdrawals as tax efficiently as possible over time. Also, consider a 1035 exchange to new fee-only annuity with lower fees if you have an older annuity. Annuity fees have come down substantially, which could save you a good amount of money over time.
Roth IRA Retirement Income
Having some diversity of taxation on your retirement income is usually good. Having some assets in a Roth IRA could help you minimize the taxes owed on your retirement income. Roth IRAs and a Roth 401(k) are funded with after-tax dollars, meaning your withdrawals can be tax-free in retirement.
The longer you have until you need to withdraw, the more valuable the tax benefits of a Roth IRA can be.
Don’t Forget Medicare Surcharges
Reminder, going on Medicare does not mean that all your premiums and medical bills are taken care of by Uncle Sam. For retirees with higher incomes, you will also pay additional surcharges for premiums on Medicare Part B (covering outpatient services) and Part D (covering prescription drugs). You may hear this called IRMAA (Income Related Monthly Adjustment Amounts), which can significantly increase your Medicare Premiums.
The state taxes you owe in retirement will depend on where you live and how much retirement income you have. Make sure state taxes are on your radar.
Tax-Planning Strategies for Retirement Income
Proactive tax planning before you retire can help you minimize your overall taxation in retirement. It can also help you avoid being shocked at how much of your budget is eaten up by taxes and Medicare surcharges. It is important to have some diversity in assets beyond just a 401(k) or other accounts where withdrawals are fully taxable and subject to required minimum distributions (RMDs).
One path forward is to fund a Roth IRA or Roth 401(k). You may also want to consider doing a Roth conversion early in retirement, especially if you are in a lower tax bracket than you will be later in retirement.
Investing in health savings accounts (HSAs) can be a great way to have tax-free income in retirement to pay for medical expenses or even medical premiums.
Also, having some of your retirement money in a taxable investment account is often helpful. This will allow you to have income taxed as capital gains. With some tax planning, you may be able to keep a good amount of this investment income in the zero percent capital gains tax bracket – making some of your withdrawals tax-free.