There are approximately 47.8 million people that are over the age of 65 in America, and that means there are hundreds of millions under that age bracket. And in today’s economy, many of those millions are thinking about taxes on retirement income.
No matter what age group you belong in, you need to start planning your income, and the taxes on retirement income stage of your life as early as possible. The sooner you prepare, the sooner you will have peace of mind for your retirement years.
Before you begin to plan, file this guide away that will teach you everything you need to know about your own taxes on retirement income.
Taxes on Retirement Income Basics
Taxes are a certainty in life, even taxes on retirement income.
The chief source of income for the United States is the income tax. And although most of us associate our paychecks with income, to the federal government, income means income.
Just as when you are working and collecting a paycheck, the amount of taxes on retirement income you will pay will depend on how much income you are bringing in. At the same time, different sources of income operate under their own set of tax rules.
Before you can plan how to pay for your taxes on retirement income, you need to learn those rules. But the first thing you need to do is be clear about your income, and you need to know every source of income that you have.
This is not as clear in retirement as in other stages of life, because when we are working, we get a paycheck and a W2 that gives us all of this information wrapped in a neat and tidy bow. But you may have savings here, which counts as income, pensions there, which counts as income, and maybe even are making dividends on stocks or bonds on a regular basis as well.
Everything needs to be listed and reported in your tax return. When you are planning taxes on retirement income, the general rule of thumb to have here is that if it is income, it will be taxed.
Don’t make the mistake of overlooking or not reporting income, as that alone could trigger an audit. Find out here the other 11 red flags that trigger an IRS audit before you begin planning taxes on retirement income.
Social Security Income
Social Security income is one of the most common forms of income for Americans over 65. It is estimated that over 67 million Americans are receiving assistance from at least one form of Social Security Assistance.
Some Americans receive OASDI, some receive SSI, and some receive funds from both programs. If this is your only source of income, it is not likely that you will be paying taxes on this.
But, if you have other income streams, then some of your SSI may be taxed. You may end up declaring as much as 85 % of your Social Security income to be taxed.
When you are paying taxes on retirement income on your Social Security income, you will be taxed anywhere from 0 to 85 %. The percentage amount will be calculated according to how much you are bringing in from other sources of income.
For tax purposes, this is referred to as your “combined income.”
So if for example, you are getting a pension from your place of work, and SSI, you will be taxed and will need to declare this combined income.
Something else that you need to consider is the Cost of Living Allowance (COLA) that SSI programs receive. Every year, amounts are adjusted by a certain amount to accommodate for the cost of living increases from year to year.
Even when COLA increases are added, however, your tax rate stays the same.
How to Withdraw from 401 (k)
Many Americans save for their retirement through plans such as an IRA or a 401 (k). But you may have retirement savings in other areas such as a 403 (b) or a 457 plan as well.
All of these forms of savings will also be considered income come your retirement years. Yes, you will have to declare it, and yes, you will have to pay taxes on it.
When you withdraw from an IRA or a 401 or 457 plan, you will be taxed on that income. The rate that you are taxed will be determined by how much income you withdraw in one year, and what you report on your tax return.
Other variables in your tax return will determine your tax rate when it comes to deductions. If your deductions are greater than your income, you may not experience taxes on retirement income that comes from savings.
The only kind of IRA that is tax-free will be a Roth IRA.
Charitable Donations From Your IRA
It seems today that you can’t turn on the TV or go anywhere without being asked to donate to a cause. If you can, you’ll be promised a tax receipt if you pledge or donate more than a certain amount as determined by the charity in question.
That amount will go towards the deductions tables in your tax return. But there are other ways to minimize taxes on retirement income using charitable donations.
You can donate to a charity directly from your IRA, either annually or even monthly if you want. This is a tax loophole that allows you to avoid income tax on as much as six figures annually.
It is important to remember that if you are using your IRA to donate to charity, you can only declare that once on your tax return.
Pension income is very similar to working income and will be taxed in a very similar way. When you are wondering what the taxes on retirement income will be on your pension income, you will likely find that your tax bracket doesn’t change too much.
But you could move into a higher bracket inadvertently based on how pension income is calculated while you are funding it. That usually happens when you are in your career and working before retirement.
Your pension account is probably funded from money calculated on your pre-taxed income. So all of the pension you receive in one year must be reported.
You will then be taxed on that income. Today, many employees can help you with those taxes on retirement income that is pension by withholding taxes from your pension funding as it is deposited.
This is a very common way to take care of those taxes before you are working on a more fixed income in retirement. Be careful not to make mistakes when declaring pension earnings.
But if you do, it’s not the end of the world. There are ways to file an amended tax return that don’t have to be stressful.
If you have life insurance, then you know of a dividend or payment you might receive in retirement called an annuity. This is a payment that you will receive from an insurance company after you have given them a lump sum or series of payments towards a policy.
How you purchased your annuity will determine how you are taxed on the income. When you are paying taxes on retirement income that is annuity-based, the tax rules that will apply will be related to what income you used to purchase the annuity.
So if you purchased it with money that had already been taxed, such as your paycheck, to plan for retirement, then you will be taxed an after-tax rate. If your annuity is bigger than what you paid into it at the time of retirement, then that surplus will be taxed as well when you withdraw it.
Annuities are often paid out in a sum with the sum being divided into principal and interest amounts. Only the interest portion is considered to be taxable income.
Every year the company from which your annuity is based will provide you with an “exclusion” amount. This is your breakdown every year on what you need to report to Uncle Sam.
A certain amount that is in your exclusion ratio will be the amount that is excluded from your overall taxable income.
Real Estate Taxes
Do you own a family business or a vacation home on one the great lakes or in the mountains? You need to consider the tax consequences that will come with any transfer to the next generation. And it is not simply federal taxes.
When you are planning your taxes on retirement income, you may have a real estate matter to consider as well. It is very common for folks in retirement to consider downsizing for a number of reasons.
The mortgage may be an expense you don’t need, or your family may be out of the nest and you just don’t need a big home anymore. Selling your home can help bring money in during retirement, but the taxman is going to come if you do this.
If you have been in your home for over two years, you likely won’t pay a capital gains tax or a tax related to money earned from the sale of your home. That is unless your gains are over $250,000 per adult in the home.
The rule gets even more complicated if you ever rent out your home. If this is the case, talk to a tax attorney about how to best work this out when planning taxes on retirement income.
The federal estate tax exemption has hovered near $5.5 million (almost $11 million per couple) for years. If an estate that cross this threshold, the federal tax rate is 40 percent. This does mean that all states follow the same approach. Currently, there are 15 states and the District of Columbia that assess an estate tax and six have an inheritance tax.
State Estate Taxes
The threshold that triggers a state estate tax assessment varies from about $1 million in Oregon to the Hawaii and Delaware that match the federal exemption. The tax rate varies even more widely from less than a percent to 20 percent as a top bracket in Washington State.
State legislation is constantly changing. For example, in Tennessee, the estate tax was phased out in 2016 and New Jersey will phase it out by 2018. Several states and the District of Columbia have also considered or have raised their exemption amounts.
How do inheritance taxes vary from estate taxes? These taxes vary based on the relationship to the person who passes away. For example, a New Jersey spouse or child receives a gift that is exempt from inheritance tax. A brother or sister receiving a gift over $25,000 would pay a graduated inheritance tax.
Tips to Avoid Audits
There is always a tax rule for every penny in your bank account, but you can minimize the tax damage if you have a lot of different retirement incomes to work with. The best rule of thumb to remember is that the more money you have, the more you will owe Uncle Sam.
So try and plan your retirement in such a way that you are minimizing this damage. Any income over $1 million is almost certain to trigger an audit.
Further, it is estimated that 35 % of those with over $10 million in annual retirement income are audited.
One way to reduce taxes on retirement income that is earned from real estate is to begin by paying off your mortgage faster. Not only will you have more in your pocket if you choose to sell your home, but you will also spread around your taxable income in retirement.
The fewer savings plans you need to draw from during retirement, the better. It’s always better if the money stays with you, right?
You may also want to consider moving. Some states have low tax audit rates, or you may just fall in a different bracket in a different state.
It is unlikely that you will move out of state on taxes alone unless you crunch some numbers and find it really could work for you. It happens all the time.
Learn more with these 8 ways to avoid a tax audit today.
Calculating Your Tax Rate
The most important thing you need to know when preparing your taxes on retirement income is not necessarily your deductions, although that is important. You need to understand your tax rate and how that is attained.
First, add up all of your income sources to get a final number for the year. Now, add up all of the deductions that you expect to be able to take from that income.
So add up all of those charity donations that you were promised a tax receipt for, and any retirement expense that you know is tax-deductible. Total those deductions.
Take the amount of the deductions and subtract that from your income. Let’s say you wind up with a number such as $36,000.
According to the tax tables, you will then fall in the tax bracket where you are taxed 15 % of that income which will be just over $4,000 dollars.
Now you just have to pay those taxes! This can be set up in installments or managed in one lump sum.
But if any single part of this confuses you, it’s always best to consult with a tax attorney. An expert will be able to help you to use deductions wisely and fit into the right tax bracket for you.
Trust the Experts
When you are planning your taxes on retirement income, the earlier you start, the better. That being said, it can never be too late to start thinking about how to do it properly as well.
But don’t start with trying to memorize the tax code, because even tax experts get confused by that sometimes. However, it is those experts that can also help you to navigate those individual and specific situations of yours, which is that tax accountants and tax attorneys do best.
Protect yourself from an audit by being prepared, and know your state audit risks as well. For example, it is estimated that Minnesota, New Hampshire, and Wisconsin have the lowest audit rates in the nation.
Additionally, American citizens making between $50 and $100,000 thousand annually are audited the least.
Start the planning now, and do it by creating multiple income streams so that when the tax bill comes, you aren’t feeling so squeezed. If you are dealing with an IRS audit or worried you might be, get instant peace of mind when you consult with a tax attorney today available 24 hours a day and 7 days a week