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How Will I Be Taxed in Retirement? A Guide to Managing Your Revenue Sources

It would be nice to ease your way into retirement, leaving your paying job behind, and think that you were done paying taxes. Unfortunately, the U.S. government doesn’t work that way. Depending on what your sources of income are during your retirement, you are likely to be responsible for at least some taxes.

As we discussed in our last monthly article, taking control of your tax situation is a critical part of planning for a comfortable retirement. So knowing what taxes are likely to serve as a drain on your finances in retirement is an important piece of knowledge to have. Here’s what you can expect:

Retirement Accounts

Distributions from 401(k) and 403(b) accounts and from traditional IRAs are taxable, as are traditional IRA distributions. Even though these accounts tend to be long-term assets, withdrawals from them are taxed at ordinary income rates rather than long term capital gains rates.

Roth IRA distributions are not taxable, nor are the relatively new Roth 401(k) accounts, which have been available to American taxpayers since 2006. Annuities are generally taxed based on the tax treatment of the accounts that originally funded them.

Investment Income

You will pay taxes on any dividends, interest income, or capital gains, just as you did before you were retired. Interest paid on investments in taxable accounts is taxed at your regular rate, but income from capital gains and qualifying dividends is taxed at the long-term capital gains rate, as long as you have owned the investment for more than one year. 

If your earned income is low enough, you will not owe federal income tax on it at all. In addition to the standard deduction, there is a “senior bonus” available to taxpayers aged 65 or more. Here’s how the thresholds break down:

  • If you are a single filer, your standard deduction is $12,200 and the senior bonus is $1,650. So if your earned income is $13,850 or less, you won’t owe any tax on it.
  • If you file jointly, your standard deduction is $24,400 and your senior bonus is $1300 per senior spouse. So if your combined income is $27,000 or less ($25,700 if only one spouse is over 65), you won’t owe any tax.

It’s also worth pointing out that while any income you receive during retirement is treated as ordinary taxable income, you no longer have to pay Social Security or Medicare taxes on that income. On the other hand, whenever you earn income from work, such as from a freelance consulting assignment, you will have Social Security taxes withheld from that income, even if you consider yourself to be in retirement.

Social Security

It may not seem right that you have to pay tax on Social Security income, but if your overall income is high enough, you will. On the more positive side, at most, you would have to pay tax on only up to 85 percent of your Social Security benefits.

The income thresholds for single filers are:

  • If your income is between $25,000 and $34,000, you may have to pay income tax on up to 50 percent of your benefits.
  • If your income is more than $34,000, up to 85 percent of your benefits may be taxable.

If you are married filing jointly:

  • If you and your spouse have a combined income of between $32,000 and $44,000, you may have to pay income tax on up to 50 percent of your benefits.
  • If you and your spouse have a combined income of more than $44,000, up to 85 percent of your benefits may be taxable.

 

Please note that these tax rates and rules can change, depending on the whims of the Congress. Because of that, planning for a retirement that is still years in advance can present a bit of a moving target. To make sure you’re still prepared for the retirement you deserve, send me an email or give me a call.

Zeroing Out Your Taxes: The Three-Bucket Retirement Strategy

Retirement planning is not exactly known for having hot new ideas, but one of the hottest to bubble up in recent years is the notion that you should aim to be paying zero taxes in retirement.   There are a couple of reasons that make this a worthy goal. It’s not just that your income and your ability to save are both dwindling or nonexistent once you stop working. You’ll also have fewer deductions at that point in your life, since your children will have grown up and your house will likely be paid off.

This is part of a strategy developed by an author and advisor named David McKnight, who has a book and podcast out called The Power of Zero, each of which expand on the concept. He’s also an affiliate of Echelon Wealth Strategies.

One of McKnight’s theories is that taxes are now historically low, and have nowhere to go up. No matter what happens in the upcoming elections, we will eventually have to deal with the fact that our debt is 108 percent of our GDP, after averaging 62 percent from 1940 until 2017. The federal deficit has reached a trillion dollars. After taxes have dropped in recent years, it is very likely that you’re going to have to pay higher tax rates in the future.

One way to deal with these realities begins with thinking of your retirement funds as going into one of three different buckets: taxable, tax-deferred, and tax-free.

  • The Taxable bucket generally includes any type of investment for which you receive a 1099 on an annual basis, like for certain work that you do. These are assets that receive no special tax treatment, either now or in the future.
  • The Tax-Deferred bucket includes retirement accounts to which you can contribute money on a pretax basis, such as a 401(k) or IRA. Although these accounts allow the assets to grow on a tax-deferred basis, when you eventually withdraw that income in retirement, it will be taxed at your highest applicable rate.
  • The Tax-Free bucket includes accounts to which you contribute after-tax money, such as Roth IRAs or Roth 401(k)s, LIRPs and others. You do not get a deduction for these contributions when you make them, but the assets and all their appreciation are income tax-free if you withdraw them after the age of 59½.

This final bucket becomes the key if you are trying to achieve zero taxes in retirement. Contributing to this tax-free bucket gives you control over how much you need to retire comfortably. You can plan your own future.

That’s not necessarily the case with the other buckets. Remember how we said we are likely to be in a higher-tax environment in the future? No matter how much money you have saved up in tax-deferred plans, you are at the mercy of wherever tax rates have landed when you reach retirement. You can plan all you want, but you still don’t know exactly how much of those funds you will be able to draw down if you don’t know how much tax you will owe on them.

Of course, there’s value in contributing to the tax-free bucket as well. These could well be your highest income-earning years, so there’s a benefit to being able to claim a deduction to reduce your current taxable income. But if you think that tax rates will increase, it may make sense to invest more in the tax-free bucket during your earning years.

Getting to zero is a tricky balance to maintain, but we at Echelon Wealth Strategies can help you find the retirement plan that suits you best. If you’d like to discuss how the ideas in this article pertain to your individual situation, give me a call at 615-505-3838.

For more information about our firm and the services we offer, send us a quick email or call the office. We would welcome the opportunity to speak with you.

info@echelonwealth.com |  (615) 505-3838