As you plot your retirement savings strategy there are many factors to consider—cost of living in your preferred locale, the lifestyle you hope to maintain, and any continuing family obligations, for example.
Here’s one expense you definitely don’t want to overlook: Taxes.
If you think tax bills are a thing of the past simply because you’re no longer working, you might be in for a rude awakening. Here are some things to consider when planning for taxes in retirement:
Believe it or not, your Social Security income isn’t necessarily tax-free: If your combined income exceeds $25,000 as an individual—or $32,000 if you’re married and filing jointly—you could owe taxes on up to 85% of your Social Security benefit payment.
In this calculation, your “combined income” is your adjusted gross income and nontaxable interest plus half of your Social Security benefits. You can make quarterly estimated tax payments to the IRS or have federal taxes withheld.
Retirement Account Withdrawals*
Most retirement money is saved pre-tax—that includes 401(k) plans, 403(b) plans, 457 plans and traditional IRAs—which is taxed upon withdrawal. Your tax rate will depend on your overall income, but it’s likely you could pay lower taxes than you would have when you first earned that money. After all, in retirement your income will usually be lower.
If, on the other hand, you saved to a Roth IRA—and you’re 59 ½ or older and have had your Roth for at least five years—you may be able to withdraw that money tax-free. That’s because you paid taxes on that money before saving it to the Roth.
Not sure of your tax bracket? Here are the numbers for 2017.
If you’re one of the lucky few who will receive a pension in retirement—only 13% of Baby Boomers have a traditional pension—and that pension account was funded with pre-tax money, you may owe taxes on the income in retirement.
If your pension was funded with after-tax money, you’re still not out of the woods—you may not owe taxes on the part of the checks that represent the after-tax money you paid.
To calculate the tax-free part, the IRS has some guidelines.
Do you receive dividends, interest income or capital gains from your investments? If that will continue to be the case in retirement—occurring in non-retirement accounts—then you may continue to pay taxes on that income.
If your income falls below a certain level, however, there may be years you could pay 0% on capital gains. In 2017, that would be single taxpayers reporting taxable income up to $37,950 and married taxpayers reporting taxable income up to $75,900.
Minimum Required Distributions*
As you’re planning your taxes in retirement, keep in mind that as you reach age 70 ½, you’ll likely have to start taking withdrawals from your IRAs or other retirement accounts. (Roth IRAs are the exception to this.)
Want to calculate what that withdrawal might look like? The IRS has a worksheet.
To estimate your taxes in retirement add up all your predicted income minus your standard deduction and any personal exemptions. Although there’s no way to predict what tax rates will look like each year of retirement, use current tax rates to get an idea of how much you might owe later. The more you can anticipate tax expenses in retirement, the more prepared you’ll be.