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.
Yes! 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, therefore you will have to pay both the federal and state governments quarterly with estimated tax payments. It is important to understand how income from your retirement sources are taxed, because each income stream is taxed differently. But how can you know how much you will owe? Below are 5 common retirement accounts and how they are taxed which is designed to help you estimate your tax bill in retirement.
1. Social Security Income
Social security taxes are an interesting animal. They range anywhere from 0% to 85% of your benefit depending on the other streams of income you have coming in.
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.
The IRS categorizes your additional income as “combined income” which can be used to calculate the approximate percentage of your benefit that will be taxed. The worksheet for this calculation can be found here.
2. Traditional IRAMost withdrawals from retirement accounts are taxed as income in retirement. With a traditional IRA, the contributions were not taxed as income, therefore the withdrawals will be.
It is good to understand that your distributions will be taxed, especially when taking into account required minimum distributions (RMD). Once you reach age 70 ½ you will need to start taking these RMDs from your account or face a ruthless 50% tax penalty on the money.
Your RMDs are income, and the IRS will tax them as such. The amount of taxes you will pay is dependent on your total amount of income, tax deductions, and your tax bracket that year.
3. 401(k), 403(b), 457(b)
Workplace retirement plans work similar to a traditional IRA. Your contributions were tax deductible therefore your distributions will be taxed as income.
401(k) plans (and its counterparts) also require RMDs when the account holder turns 70 ½ . Forgetting to take an RMD is an easy yet costly mistake. Make sure that you are up to date on your distributions to avoid the tax penalty.
Similar to a traditional IRA, the amount you will pay in taxes from your workplace retirement plan rests on 3 factors: the amount of income, your taxable deductions, and your tax bracket.
4. Pension Payout
Most pension plans are funded with pretax dollars, therefore most are subject to income tax in retirement. This structure is similar to 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.In the case that some of your pension was funded with taxed dollars, a portion of your income will be taxed while the other is not.
5. Annuity Payments
Annuity distributions can get a little bit more tricky because your taxable income is dependent on the type of annuity you buy. If the annuity is through an IRA or other retirement account, then the tax rules from that IRA account will be upheld.
If your annuity was purchased with after-tax dollars then you are faced with two scenarios:
With an immediate annuity the money you receive is divided into two parts: return and interest. Only the interest portion will be taxed as income. The company you purchased this from will show you that ratio each year.
Fixed or Variable annuity
The tax rules on this type of annuity depend on the overall worth of the account. If the account is worth more than when you contributed, your earnings will be looked at as investment income and will be taxed. After all of your earnings are withdrawn, you are not responsible for paying income tax on your original contributions.
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.
The contributions to this account were with after-tax dollars, therefore the distributions are often tax-free (as long as the distribution rules and guidelines are followed).
Having an understanding of 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. Use the list above to help you calculate the amount you will owe to keep you prepared for the new ways you will do your taxes in retirement.