How to Estimate Taxes in Retirement
Don't get caught off guard by your tax bill in retirement
You will continue to pay taxes in retirement. Taxes are calculated on your income each year as you receive it, much like how it works before you retire. It's important to estimate the amount of taxes you'll pay in retirement so you can budget for it and set up your tax withholdings (or quarterly payments) in advance.
Each type of income you receive will have different tax rules that apply to it. To estimate (and minimize) your taxes in retirement, you need to know how each income source shows up on your tax return. Here are the six most common types of retirement income that are taxed, and an example of how to estimate your tax rate and total taxes in retirement.
Social Security Income
If your only source of retirement income is Social Security, then you probably won't pay any taxes in retirement. If you have other sources of income, then a portion of your Social Security income is likely to be taxed. A formula determines the amount of your Social Security that is taxable. The result is that you may have to include up to 85 percent of the Social Security benefits as taxable income on your tax return.
The amount that is taxable (anywhere from zero to 85 percent) depends on how much other income you have in addition to Social Security. The IRS calls this other income "combined income," and in the you plug your combined income into a formula to determine how much of your benefits will be taxable each year.
Retirees with a high amount of monthly pension income will likely pay taxes on 85 percent of their Social Security benefits, and their total tax rate may run anywhere from 15 percent to as high as 45 percent. Retirees with almost no income other than Social Security will likely receive their benefits tax-free and pay no income taxes in retirement.
IRA and 401(k) Withdrawals
Most withdrawals from retirement accounts are taxed in retirement. This means IRA withdrawals as well as withdrawals from 401(k) plans, 403(b) plans, 457 plans, etc., are reported on your tax return as taxable income. Most people will pay some tax when they withdraw money from their IRA or other retirement plans.
The amount of tax you pay depends on the total amount of income and deductions you have and what tax bracket you are in for that year. For example, if you have a year with more deductions than income (such as a year with a lot of medical expenses), then you may not pay taxes on withdrawals for that year.
There is one type of retirement account where withdrawals are usually tax-free. If done correctly, you will pay no retirement taxes on Roth IRA withdrawals.
Most pension income will be taxable. The easiest way to determine the likelihood that your pension income will be taxed is to use a simple guideline: if it went in before tax then when you withdraw it, it will be taxed. Most pension accounts are funded with pre-tax income, which means the entire amount of your annual pension income will be included on your tax return as taxable income each year. In this case, you can ask that taxes be withheld directly from your pension check.
If a portion of your pension account was funded with after-tax dollars then each year a portion of your pension income will be taxable and a portion will not.
If your annuity is owned by an IRA or another retirement account, then the tax rules in the section on IRA withdrawals will apply to any withdrawals or annuity payments you receive from that annuity.
If your annuity was purchased with after-tax dollars (meaning not purchased within an IRA or another retirement account) then the tax rules that apply depend on what type of annuity you purchased.
- Income from an immediate annuity—A portion of each payment you receive from an immediate annuity is considered a return of principal and a portion is considered interest. Only the interest portion will be included in your taxable income. Each year the annuity company can tell you what your "exclusion ratio" is, which tells you how much of the annuity income you receive can be excluded from your taxable income.
- Withdrawals from a fixed or variable annuity—The tax rules on these types of annuities say that earnings must be withdrawn first, which means if your account is worth more than what you contributed to it, when you take withdrawals, initially you will be withdrawing earnings or investment gain, and it will all be taxable income to you. Once you have withdrawn all your earnings, then you will be withdrawing your original contributions (called your cost basis), and those are not included in your taxable income.
You will pay taxes on any dividends, interest income, or capital gains, just as you did before you were retired. These types of investment income are reported on a 1099 tax form each year which is sent to you directly from the financial institution that holds your accounts.
If you systematically sell investments to generate retirement income, each sale will generate a long or short term capital gain (or loss) and that gain or loss will be reported on your tax return. If your other income sources are not too high you may qualify for the zero percent capital gains tax rate—which means you would pay no tax on all or a portion of your capital gains for that year.
If you own investments that are not inside of a retirement account you can learn how to manage your capital gains and losses to reduce the taxes that you pay in retirement.
Not every source of cash flow from investments is counted as taxable income. For example, assume you own a bank CD. The CD matures in the amount of $10,000. That $10,000 is not extra taxable income to be reported on your tax return—only the interest it earned is reported. But the entire $10,000 is available as cash flow you can use to cover expenses.
Gains Upon Sale of Your Home
If you have lived in your home for at least two years then most likely you will not pay taxes on gains from the sale of your home unless you have gains in excess of $250,000 if single, or $500,000 if married. If you rented your home out for a while, the rules get more complex and most likely you will need to work with a tax professional to determine how any gains need to be reported.
Calculating Your Tax Rate in Retirement
Your tax rate in retirement will depend on your total amount of income and deductions. To estimate the tax rate list each type of income, and how much will be taxable. Add that up. Then reduce that number by your expected deductions and exemptions.
For example, assume you are married and you will have $20,000 of Social Security, $25,000 a year in pension income, you expect to withdraw $15,000 from your IRA, and you estimate you'll have $5,000 a year of long-term capital gain income from mutual fund distributions. You add up your ordinary income (not including capital gains) using 85 percent of your Social Security benefits and get $57,000.
Your standard deduction and personal exemptions add up to $20,800. That puts your estimated taxable income at $36,200. You look up the 2017 tax rates and see that puts you in the 15% tax bracket. As the tax rates are tiered, you'll pay 10% on the first $9,325 of taxable income and 15% on the income that falls between $9,326 and $37,950. That makes your estimated tax bill $4,963. As you are in the 15% or lower tax bracket, your capital gains will qualify for the zero percent cap gains rate and will not be taxed.
To pay your taxes in a timely manner you could either set up quarterly tax payments of $1,240 per quarter, or you could ask your pension to withhold taxes at about a 20% rate.
There are certainly ways to structure your retirement income so that you pay less taxes in retirement—it will take research on your part or the assistance of a professional retirement planner or tax advisor.