Taxes are, unfortunately, a part of life. Even during retirement, you may have to pay income taxes on your retirement fund withdrawals and Social Security benefits, and those taxes can greatly reduce your income.
Although taxes may be unavoidable, planning them now can make them a little more bearable in retirement. To prepare for them, it is first important to understand how taxes will affect your retirement income.
How taxes affect your 401 (k) and IRA
Traditional IRAs and 401 (k) accounts are tax-deferred retirement accounts, which means you’ll get a tax deduction when you make the initial contribution, but you’ll have to pay taxes when you withdraw your cash. With Roth IRA accounts, on the other hand, you will pay taxes up front, but your withdrawals will be tax free.
If you’re saving in a 401 (k) or traditional IRA, you can expect to pay income taxes on your retirement withdrawals. But exactly how much you will pay depends on your tax category. If your spending levels don’t change much between now and retirement, you may be in the same tax bracket once you retire. But if you expect to spend significantly more or less on retirement than you earn now, you could end up with a higher or lower tax bracket.
Tax rate | Annual income for individuals | Annual income for married couples filing a joint return | Annual income for heads of household |
---|---|---|---|
10% | $ 0 | $ 0 | $ 0 |
12% | $ 9,875 | $ 19,750 | $ 14,100 |
22% | $ 40,125 | $ 80,250 | $ 53,700 |
24% | $ 85,525 | $ 171,050 | $ 85,500 |
32% | $ 163,300 | $ 326,600 | $ 163,300 |
35% | $ 207,350 | $ 414,700 | $ 207,350 |
37% | $ 518,400 | $ 622,050 | $ 518,400 |
Please note that this is a progressive tax system, which means that whatever level of tax you belong to, you will not pay that rate for all of your income. So if you withdraw $ 50,000 per year from your 401 (k) or traditional IRA, for example, you will pay 10% on the first $ 9,875, then 12% in the amount of $ 9,875 to $ 40,125, then 22% on the amount of $ 40,125 to $ 50,000.
Another tax factor to consider with traditional 401 (k) and IRAs is their minimum required distribution (RMD). Once you turn 72, you will be asked to start withdrawing a certain amount from your 401 (k) or traditional IRA, since those accounts are tax deferred and Uncle Sam finally wants your money. If you don’t start taking RMDs on time, you will have to pay a sizeable tax penalty of 50% of the amount you were required to withdraw.
Taxes on Social Security benefits
Depending on how much you receive from Social Security, you may also owe taxes on your benefits. The good news is that no matter how much you earn, you will not pay taxes on the full amount of your benefits. However, you could owe taxes on up to 85% of your profits.
To determine how much you owe in taxes, you must first know your “combined income,” which is half the amount of your annual Social Security benefit plus any other source of income (however, Roth IRA withdrawals are excluded). So, for example, if you receive $ 20,000 per year in benefits and withdraw $ 40,000 per year from your 401 (k) or traditional IRA, your combined income is $ 10,000 plus $ 40,000 or $ 50,000.
Percentage of your profits that will be taxed | Annual combined income for individuals | Annual combined income for married couples filing a joint return |
---|---|---|
0% | Less than $ 25,000 | Less than $ 32,000 |
Up to 50% | $ 25,000 to $ 34,000 | $ 32,000 to $ 44,000 |
Up to 85% | Over $ 34,000 | Over $ 44,000 |
If these income limits seem low, it is because they have not been adjusted since Social Security benefits were first taxable in 1984, even though benefits are slightly increased each year to account for inflation. That means more retirees are likely to end up paying taxes on their benefits in the future if the income limits remain the same.
How to Minimize Taxes in Retirement
One of the best ways to prevent taxes from lowering your retirement income is to invest in a Roth IRA account. You will have to pay taxes in advance, but you will not pay any tax on your retirement withdrawals. Also, because Roth IRA withdrawals do not count toward combined Social Security income, that could lower your taxes on your benefits.
You may not be able to stop paying taxes entirely in retirement, but taking steps now to determine what your tax situation will be like and lowering your future taxes as much as possible will help you maximize your retirement income.