When you retire, you leave many of the stresses of work behind, like commuting, constant email notifications, and subpar coffee. However, there is one burden that doesn’t disappear completely – taxes.
Unfortunately, taxes are still a concern during retirement, but your overall tax burden and your plan for addressing these costs may look very different than during your working years. As you craft your plan to manage retirement taxes, include these five common types you may be required to pay.
1. Certain Types of Retirement Income Are Taxed
Federal and state income taxes are unwelcome but familiar expenses during your working years, and they continue in retirement. Several types of income you may receive in retirement are taxable, so be sure to pay close attention to the following details.
Traditional IRA and 401(k) Distributions Are Typically Subject to Income Tax
You likely received an income tax deduction when you contributed to a Traditional retirement plan, and the earnings in these types of accounts grew tax deferred. However, the tax benefits end when you withdraw the funds during retirement. At that time, you generally owe ordinary income tax on your distributions at both the federal and state levels.
Tax on your withdrawals can be disheartening, but there is a bright side. You generally do not owe the Federal Insurance Contributions Act [FICA] portion of tax you were accustomed to paying during your working years. This tax is 6.2% for employees, but it only applies to earned income – like wages. Without FICA taxes, your overall tax rate may decline once you start taking retirement account withdrawals.
Pension Income Is Generally Subject to Income Tax
Pensions are few and far between in today’s job market, but if you were fortunate enough to snag one when they were popular, you will also need to contend with taxes on your income. These retirement accounts are generally funded with pre-tax dollars, similar to Traditional retirement plans. If your pension was funded this way, you’ll owe income tax on the income you receive – but you won’t owe FICA tax.
Some Of Your Social Security Income May Be Subject to Tax
Many people believe that Social Security income is exempt from taxes. However, over half of households receiving Social Security today owe tax on their benefits.
To determine if you will owe taxes on your benefits, you first need to calculate your Provisional Income. This calculation includes nontaxable interest and ½ of your Social Security benefits.
Once you have your Provisional Income, you can determine whether you will owe tax on none, 50% or 85% of your benefits.
You’ll avoid Social Security tax if:
- You are single and your Provisional Income is under $25,000.
- You are married filing jointly and your Provisional Income is under $32,000.
You’ll owe tax on up to 50% of your benefits if:
- You are single and your Provisional Income is between $25,000 and $34,000.
- You are married filing jointly and your Provisional Income is between $32,000 and $44,000.
You’ll owe tax on up to 85% of your benefits if:
- You are single and your Provisional Income is over $34,000.
- You are married filing jointly and your Provisional Income is over $44,000.
Dividends from Investments Held in Non-Retirement Accounts are Often Taxable
While investment earnings in a retirement account are tax-deferred, gains in a non-retirement account are not. You will generally owe income tax on dividends in the year you earn them in an account that is not designated as a retirement account – such as a brokerage account, or even a money market account at your bank. You owe these taxes even if you don’t make a withdrawal from the account.
2. Capital Gains Tax on Non-Retirement Account Gains
When you sell an investment in a non-retirement account, you could also owe capital gains tax. This type of tax applies to the difference between the purchase price of the security and the price for which you sold it.
Capital gains tax rates differ depending on how long you hold an investment. If you own it less than one year, you will be taxed at short-term capital gains tax rates, which are the higher of the two options. If you hold it longer than one year, you will be taxed at long-term capital gains tax rates, which are lower.
It is also important to consider that capital gains tax is owed on the aggregate amount of gains you have in a particular year. If you lose money on some investments, and gain money on others, you only owe tax on your net gain.
Capital gains taxes are not just for securities. You could also owe them if you sell art, collectibles, or property – though there is an exception for your principal residence. For this reason, it is wise to consult an experienced financial advisor before selling any large asset, whether it is a stock, bond, or real property.
3. Net Investment Income Tax
If you have income over certain thresholds, you may be subject to an additional 3.8% tax on investment gains known as the Net Investment Income Tax [NIIT]. The thresholds are not adjusted for inflation, and are currently:
- $200,000 for single filers or head of household
- $250,000 for married filing jointly or qualifying widow(er)
- $125,000 for married filing separately
This tax applies to dividends, capital gains, rental income, non-qualified annuities, and some types of passive business income. However, it does not apply to withdrawals from qualified retirement plans, wages, Social Security benefits, alimony, tax-exempt interest, self-employment income, or income from a nonpassive business.
4. Property Taxes
Another type of tax that you are likely familiar with is property tax. These taxes apply to real property that you own like a car, boat, home, or investment property.
Property tax rates vary widely by state and municipality, with the most expensive states charging over 2% of property value each year. These taxes can be difficult for retirees on a fixed income to fit into their retirement plan.
Fortunately, some states have discounted property tax rates for seniors or even no tax at all. For example, our home state of Alabama allows exemptions for people over age 65 from the state portion of property tax.
5. Estate Taxes
Retirement is also the time in which many people update their estate plans and move assets to their intended beneficiaries prior to their passing. If your net worth is substantial, you may need to contend with gift and estate taxes during this process.
The “One Big, Beautiful Bill Act” permanently raised the estate and gift tax exclusion and it now applies to individuals with assets over $15 million and couples with assets over $30 million. The gift tax is applied to annual gifts over $19,000 per beneficiary once the giver has exhausted their estate tax exemption.
If you plan to gift assets that are in excess of the annual gift tax exclusion limit, or if you have total assets exceeding the estate tax exclusion, it is wise to work with an experienced financial advisor. Your advisor can help you develop strategies for moving assets to your heirs while minimizing their tax burden.
Include Uncertainty in Your Retirement Tax Plan
As the passing of the “One Big, Beautiful Bill Act” showed, tax law can change quickly. Consequently, the tax rates that apply to you when you first retire could change dramatically, even if your income and assets remain stable.
Due to the ability of Congress to change tax law frequently to suit political needs, you need to factor some uncertainty into your retirement tax plan. An experienced financial advisor can help you make a plan to address taxes that includes current tax law and helps you prepare for any changes on the horizon.
Plan A Successful Retirement with Meld Financial
At Meld Financial, our team of tax, legal, and investment professionals can help you plan for the most important aspects of your retirement, like tax strategies. Our comprehensive wealth management plan, Financial Fingerprint®, assesses your tax situation before our advisors recommend tailored strategies.
In addition to taxes, Financial Fingerprint® brings together the crucial components of your retirement plan like Social Security, Medicare, and investments. This nimble plan adapts to your changing circumstances, so it grows with you as your life and family change.
To learn more and get started, contact us today.
