How Retirement Can Affect Your Tax Return

When planning to retire, many individuals forget to account for taxes. In retirement, you receive income from entirely different sources than you did when you were working. This can impact your taxable income as well as tax bracket. Planning for this, prior to retirement, can save you money in the long run.

Estimating Your Tax Rate Before Retirement

Estimating your taxable rate once reaching retirement is important to determine whether you should contribute to a pre-tax retirement plan or an after-tax retirement plan. Individuals often overestimate what their tax rate will be, which can cause them to select the wrong type of retirement plan. Estimating this now can also help you better determine how much you will need to save in order to cover all expenses.

When considering your rate, keep in mind that the only items taxed at ordinary tax rates upon retirement are rental income, pensions, withdrawals from a taxable retirement account, wages and business income. Social Security, savings investments and long-term capital gains are taxed at a lower rate, and your withdrawals from your Roth account will generally be tax-free as well (with a few exceptions for early retirement and newer accounts).

Many experts suggest that retirees only need about 80 percent of their pre-retirement income once they become retired. This is because your general expenses may be less. Consider the following examples:

  • Children are generally no longer financially dependent on you.
  • You are no longer spending money on work related expenses such as commuting to work, business attire, and meals outside of home.
  • Some retirees may also end up downsizing their home or vehicle(s).

Further, the standard deduction if you are over the age of 65 when you retire is higher.

Tax Treatment of Various Retirement Accounts

If you withdraw from a pre-tax plan, like a 401(k), you will need to plan on paying taxes at your ordinary rate for that income. Often, taxes may be withheld from withdrawals, but that deduction may not be sufficient to cover your entire tax bill.

IRAs can be partially or fully taxable. They also may not be taxed at all, depending on if the contributions were made with pre or after-tax dollars. With Roth IRAs, for example, you do not have to pay taxes on the funds withdrawn.

Taxpayers also have the option of converting pretax IRA plans to a Roth. This is typically done in an effort to decrease tax obligations once in retirement.

It is important to keep in mind that some retirement accounts have minimum withdrawal amounts. Be sure to adhere to these requirements to avoid costly penalties and fees.

Looking for more information about how retirement can impact your taxes? You can find more in our article on The Tax Advantages of Retirement Programs.

How Is Social Security Income Taxed?

For many years, Social Security benefits were not taxable. However, newer initiatives have attached a tax to portions of Social Security benefits if your income is above a certain level. These taxes help fund Medicare. Nonetheless, everyone who receives Social Security benefits receives at minimum 15 percent of the income tax-free.

As a rule, unless you have substantial income outside of Social Security, you will not be required to pay taxes on your Social Security benefits.

Outside income can come from:

  • Employment
  • Dividends
  • Interest
  • Capital gains
  • Pass-through Business

Income from these sources must be reported on the taxpayer's income tax return along with the amounts that you receive for Social Security benefits. Social Security benefits are taxed based on “combined income” or one half of received benefits plus all other income.

Ten's of millions of retirees will pay taxes on some portion of their Social Security benefits. Those who are expecting to pay taxes on their Social Security benefits can make quarterly estimated tax payments to the IRS, or arrange for taxes to be withheld.

 

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