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Taxes and retirement are like two peas in a pod; you don't get one without the other. Fortunately, planning opportunities available may allow you to reduce the amount of taxes you pay and relieve you of some of the potential pain associated with it.
Effectively managing your tax bracket in retirement starts with understanding how your income sources are taxed.
Let's review how common retirement income vehicles are taxed and what you can do to prepare.
You may want to download our 2023 tax reference cheat sheet to reference as you read.
Why Tax Planning Is So Important In Retirement
Taxes are an unavoidable part of life both before and during retirement, but that doesn’t mean you need to pay more than you have to.
You've worked hard for your money and made sacrifices along the way to accumulate your savings. Important to keep the funds you need to support the lifestyle you’ve earned for yourself.
Taxes can be a drain on that support.
That’s why planning becomes critical - especially in retirement. Proactive tax planning helps you pay as little tax as possible without running afoul of the law. It’s a key piece of every retirement plan we help with.
We look for opportunities to maximize your income and minimize taxes long-term, and help you identify the best way to combine and implement strategies most effectively. (Roth conversions, tax loss harvesting, deferring income, strategically realizing gains and losses, etc.)
Of course it all starts with understanding the basics. To make good strategic choices, you must know how the IRS taxes your retirement income.
How Do You Pay Taxes In Retirement?
The mechanics may also change some in retirement depending on what you are used to and the type of income sources you’ll have in retirement.
Most employees are accustomed to having taxes withheld from their paychecks while they are working. This makes actually paying taxes pretty easy because your employer handles it for you.
Some types of retirement income allow you to do the same. For example, you can have taxes directly from your Social Security "paycheck." Doing so helps ensure you're paying enough to the IRS throughout the year to avoid penalties.
However, it doesn’t always work this way. If you have a lot of investment income or other types of income (such as rental income) that you can't automatically withhold, you'll likely have to make estimated payments throughout the year. Paying them late (they are typically due on a quarterly schedule) or not paying the correct amount can result in additional penalties. Avoiding these penalties is one easy way to save.
Your financial advisor and CPA or tax preparer can help you keep track and determine the best payment strategy for you.
How Your Income Is Taxed In Retirement
Now, to the fun part. Let's review! Here is how each of the most common retirement income items are taxed:
Social Security: Your benefits are taxed like ordinary income. The good thing is, not all of your benefits are subject to taxation. At most, 85% of your benefit is taxed so 15% is tax-free! As mentioned before, you can ask that the SSA withhold estimated taxes as well as Medicare Part B premiums. We recommend doing this to avoid any potential hiccups.
Pensions & Qualified Annuities: These are also taxed as ordinary income. You can either decide on fixed monthly payments or a lump sum. While fixed payments offer stability, a lump-sum could help you gain more returns if invested appropriately. Also consider that a lump sum payment lumps your tax liability too. You’ll want to carefully weigh your options.
Traditional 401k and IRA accounts: (including non-deductible IRAs): Again, distributions on any pre-tax earnings are subject to ordinary income tax. A distribution of after-tax contributions are not taxed, but the earnings are always taxed. The key thing here is timing your withdrawals to minimize the taxable impact. This could include converting to Roth accounts while working or during early retirement or taking distributions before RMDs begin. Once RMDs start QCDs are another great avenue to explore.
Roth 401k and IRA: These are powerful tax tools because qualified distributions aren't taxed at all. This gives you more freedom over your cash flow and tax bracket. With a combination of Roth and traditional accounts you have a lot of flexibility to maximize planning opportunities.
Health Savings Account or HSA: Qualified distributions aren't taxed. You can take tax-free withdrawals from your HSA to pay for qualified medical costs - like expenses that Medicare doesn't cover. This includes things like hearing aids, dental and vision expenses, long-term care (insurance or the care itself), and additional out of pocket expenses like co-pays and prescriptions.
Brokerage account: Money held outside of retirement accounts adds a layer of complexity but also additional planning opportunities. Withdrawals of cost-basis from taxable accounts aren’t taxed, but the gains on the investments are. This is very different from the way retirement accounts work. Investments are taxed according to capital gains rules. Short-term gains are taxed as income, while long-term gains are taxed at either 0%, 15%, or 20% according to how much other income you have.
Real estate: Here again, capital gains tax comes into play. You may also have deductions that you can use to offset gains for things like repairs and property management expenses.
Actively Managing Your Tax Bracket Matters
Once you know all of your income sources and how they are taxed, you can combine them to figure out your total tax liability. As you might expect though, it’s not as simple as just adding them all together. That’s because there is considerable interplay between them.
An important tax number to know is your adjusted gross income or AGI and your modified adjusted gross income or MAGI. The reason it’s critical is because it can determine how much tax you'll owe on your Social Security benefits, whether your Medicare premiums will go up due to the income-related monthly adjustment amount (IRMAA), or even if you’ll be subject to completely new taxes like the net investment income tax!
Adding up all of your sources of income and understanding not only how each is taxed, but how they affect one another can be confusing.
Then, thinking about how to navigate planning through it can become overwhelming. Don’t worry - we can help!
Please reach out to us to schedule a time to chat today.
Author: Scott Hurt, CFP®, CPA
Scott is a fiduciary, fee-only financial advisor at Covenant Wealth Advisors serving clients across the United States. He specializes in helping individuals aged 50 plus create, implement, and protect a personalized financial plan for retirement.
Disclosures: Covenant Wealth Advisors is a registered investment advisor with offices in Richmond and Williamsburg, VA. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. The views and opinions expressed in this content are as of the date of the posting, are subject to change based on market and other conditions. This content contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Please note that nothing in this content should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and you should not consider anything to be, investment, accounting, tax, or legal advice. If you would like accounting, tax, or legal advice, you should consult with your own accountants or attorneys regarding your individual circumstances and needs. No advice may be rendered by Covenant Wealth Advisors unless a client service agreement is in place.
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