Estimating Taxes in Retirement

As you work hard work to amass a healthy nest egg, you probably look forward to enjoying the fruits of your labor in retirement. But even though you’ll eventually see a return on all those years of investment in Social Security and savings vehicles, it unfortunately doesn't mean your days of making payments to the Internal Revenue Service (IRS) are over.

In fact, many retirees are as surprised to find they owe taxes on retirement income as they were when they got their first paycheck as a teen and realized taxes had consumed a sizable bite. In order to create an adequate savings plan, it's imperative to understand your share of retirement taxes well before you arrive at your golden years.

While it’s impossible to estimate the exact amount you'll owe on taxes in retirement, it’s important to at least understand how it works. The amount you owe will be based on your tax rate when you retire, and you can find a chart of current marginal tax rates here. You’ll determine your combined income from both earned income (from part-time or consulting work), as well as unearned sources (income from investments such as those detailed below). It’s important to note that tax law is ever-changing, so it’s vital to update your plan regularly—and refer questions to a financial advisor and/or tax professional.

Wondering what kinds of taxes you'll pay in retirement? Here are some of the common types of income that trigger taxes in retirement, along with pointers to help reduce your share of the bill.

Social Security

If Social Security is your sole source of income, you probably won’t owe taxes on it. However, based on income derived from other sources, such as those below, you could owe taxes on up to 85% of your Social Security check.

How Much Will I Owe?

If your income as an individual filer is currently between $25,000 and $34,000, you will pay tax on approximately 50% of your Social Security payout. If your income is more than $34,000, this rises to up to 85%. The IRS’ Social Security tax worksheet can help you plan if and what you may owe, but it's important to remember these formulas can change over time.

What Can Be Done:

Most of us have the age of 65 firmly etched in our brains as the year retirement officially begins. However, one strategy to avoid paying taxes on your Social Security benefits is to wait longer to take them, which has the added bonus of allowing you to earn more in future benefits. Because the program is based on a variable timeline, it pays out more when you wait longer to take benefits. So if you wait until age 70, which is the latest year you can start collecting, you’ll not only receive an additional 24% in your monthly benefits for the rest of your life, you'll also delay tax payments.

Withdrawals from Investment Plans

Most advisors consider socking away funds in a 401(k) or Individual Retirement Account (IRA) a savvy savings vehicle—and they certainly can be. However, it’s important to note that the tax advantages you enjoy today mean you'll need to pay taxes in retirement when you eventually withdraw the funds. This is because most retirees are in a lower tax bracket than they were during those peak earning years when they were actively saving for retirement, and would ideally pay less tax overall.

How Much Will I Owe?

The amount you owe will depend on your income and tax bracket at the time you begin withdrawing. It’s important to note that even though you might have held these assets for a long time, this income doesn’t qualify for long-term capital gains, which can have a lower tax rate, but as ordinary income. By law, you must start taking required minimum distributions annually from IRAs and 401(k)s at age 72.

What Can Be Done:

Even though it’s great to enjoy the tax advantages now, you might want to balance this potential future outlay by evaluating whether you qualify for vehicles like Roth 401(k)s and IRAs where you pay the taxes upfront in exchange for tax-free withdrawals. Many consumers find a blend of both types of accounts allows them to best balance the tax issue.

Pensions

The majority of pensions are funded with pre-tax dollars, which means you will need to pay taxes in retirement on the entire withdrawal. However, other types might be funded with a blend of pre-tax and after-tax dollars, which means you won’t pay taxes on the portion you’ve already covered.

How Much Will I Owe?

As with withdrawals from investment plans, pension funds will be taxed as ordinary income at your assessed tax rate.

What Can Be Done:

In many plans, you may request that the taxes be withheld from each pension check. While this doesn’t minimize the amount you owe per se, it does mean you won’t be hit with a lump sum come tax time.

Investment Income

You won’t be caught off guard with this one because you’ll be paying the same type of taxes as you are paying now before retirement—on dividends, interest income and capital gains if you sell the investment.

How Much Will I Owe?

It depends what types of investments you have since not all will pay dividends. It also depends on what types of moves you make each year and whether you sell at a profit or loss.

What Can Be Done:

You’ll pay more in short-term capital gains on any investment you hold for less than a year, so it may be wise to wait until you reach that threshold before selling. Of course, there may be circumstances that make it advantageous even if you're still in the window of short-term capital gains, so it's wise to work with a financial advisor. You also may be able to qualify for the 0% capital gains tax rate if you "harvest” your long-term capital gains—which means carefully determining which accounts to sell in any given year and intentionally selling an investment in a year when there is no gain. This can be a somewhat complicated tax planning strategy, so it’s best to have a discussion with your financial advisor to make sure you understand this move's implications and whether it suits your goals.

Annuity Distribution

Annuity payments come in two forms—principal and interest, and you’ll only pay tax on the interest portion. When you receive the income, the company will let you know which portion must be included in your taxable income.

How Much Will I Owe?

Be prepared that the rules on annuity withdrawals dictate that interest must be withdrawn first, so if the annuity is worth more than you originally contributed, the entire amount of those first interest payments will be taxable.

What Can Be Done:

Purchasing an annuity as part of your Roth IRA (the type of account you buy with after-tax dollars) means that the annuity withdrawals will be tax-free, provided you’ve owned the account for five years and are older than 59 and a half.

Determining the amount of taxes you'll pay in retirement can be a complicated, so it's always best to speak with a financial advisor and tax professional about your goals and unique situation. Remember that tax laws change frequently, so set time aside each year to visit with a financial advisor so you can make the right moves now and ensure you're paving the way to a comfortable retirement.