Your lifestyle will change when you retire. From your routine to your hobbies to your money, you will see a significant shift in the operation of your daily life. One thing that will not change however, is paying taxes.
Taxes will still be involved in your financial responsibilities when you retire. The money generated from your retirement account is income and will be taxed as such just like it was before.
The difference is that now your employer is not withholding taxes from your paycheck. Below are 4 common retirement income sources and how they are taxed, which is designed to help you estimate your tax bill in retirement.
1. Social Security Income
If you solely rely on Social Security benefits for your retirement income, you will likely pay 0% in taxes. But that is often not the case for many retirees. Those who have additional sources of income such as pension payouts or annuities can see up to 85% of their Social Security benefit taxed as income.
2. Traditional IRA and Workplace Retirement Plans
Most withdrawals from retirement accounts are taxed as income in retirement. If the contributions were not taxed as income, the withdrawals will be.
It is important to understand that your distributions will be taxed, especially when considering required minimum distributions or RMDs. Once you reach age 72 you will need to start taking these RMDs from your account or face a ruthless 50% tax penalty in addition to taxes on the money.
3. Pension Payout
Most pension plans are funded with pretax dollars; therefore, most are subject to income tax in retirement. This structure is like both the traditional IRA and workplace retirement accounts: if it goes in pre-taxed, it comes out taxed. Since you will likely owe income taxes on the entire balance of your pension plan, you can ask that income tax be withheld from your monthly check.
As you can see, most of the accounts you contributed to in your working life are subject to taxes when you retire. There is one account, though, that isn't.
That leads us to…
4. Roth IRA
The contributions to this account were made with after-tax dollars, therefore the distributions are often tax-free as long as the distribution rules and guidelines are followed.
Understanding your tax bill in retirement will help you plan the way you want to schedule payments, take RMDs, and supplement your retirement income. Remember, most of your taxes will be dependent on your level of income, tax deductions, and your tax bracket.
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