Paying taxes to Uncle Sam doesn't stop when you're enjoying your golden years of retirement. In fact, many retirees can be surprised that they will owe taxes on income such as Social Security benefits and annuities.
Knowing the role taxes play in your retirement is key to planning for those later years, so you're not caught off guard. Here’s how much retirees can expect to pay taxes, depending on income, according to experts and financial planners.
Based on Internal Revenue Service (IRS) rules, certain Social Security beneficiaries pay taxes on up to 50% of benefits.
Those who must pay federal income taxes on Social Security benefits have other significant income aside from their benefits, including wages, self-employment, interest, dividends and other taxable income that must be reported on a federal tax return.
The IRS breaks it down and draws the distinction based on annual earnings for individual filers and joint filers.
Individual filers with earnings between $25,000 and $34,000 can expect to pay income taxes on up to 50% of benefits. Those making more than $34,000 can expect to pay taxes up to 85% of benefits.
Joint filers making between $32,000 and $44,000, can expect to pay income tax on up to 50% of benefits. Married couples making more than $44,000 can expect to pay taxes on up to 85% of benefits.
401(k)s and 403(b)s
Traditional 401(k)s and 403(b)s for nonprofit employees are considered among the most popular retirement savings tools because of the tax advantages and the availability of employer matching programs. Contributions are generally automated, making for easy savings with pre-tax dollars which lower your annual taxable income.
“The only time you're taxed on those types of accounts is when you take distributions from them,” said James Ciprich, certified financial planner and wealth advisor with RegentAtlantic Capital. “And it's taxed at ordinary income rates, same as earned income for the most part.”
Retirees don't have to take a required minimum distribution, or RMD, from their retirement accounts until they reach 72. Once that happens, the size of the distribution could tip the retiree's current income into a higher tax bracket when included with other income. Keep in mind that withdrawals before age 59½ are also taxed and trigger a 10% penalty.
The appeal of individual retirement accounts (IRAs) is that it can be a supplemental savings vehicle to a 401(k) or 403(b) because $6,000 ($7,000 for those age 50 and up) pre- or post-tax dollars can be contributed this year. There are key differences between the two types of IRAs and how they're taxed.
With a traditional IRA, Ciprich pointed out “you get a deduction on the money that you put into them” because those contributions are made with pre-tax dollars. The earnings in the traditional IRA are tax deferred until you’re required to start taking distributions at age 72.
Those withdrawals are taxed as regular income the rate is based on your income the year you made the withdrawal. If you take out money before age 59½, that is considered an early withdrawal and comes with a 10% penalty and in most cases, any associated income taxes.
Roth IRAs grow with post-tax dollars, but “there is no income tax paid on either the gain or the distribution,” Ciprich explained, provided you meet certain requirements. Contributions you made can be withdrawn tax-free at any time. Earnings can be taken out tax-free as long as you’re 59½ or older and you had the Roth IRA for at least five years.
Unlike a traditional IRA, contributions you make into a Roth are not tax deductible.
Since pensions are so expensive for corporations to guarantee a percentage of an employee’s salary post-retirement, the plans have largely been phased out but are still prevalent in public-sector and often unionized roles like law enforcement or education.
Regardless of how you earned your pension, Ciprich explained since most pensions are funded with pre-tax dollars, taxation comes with withdrawal and usually “taxed based on your level of taxable income.”
Annuities grow tax-deferred and are taxed depending on the type of annuity, how the annuity was purchased and its term, and how withdrawals are made. Because of annuity taxation complications, you might want to consult with a financial professional.
Annuities are either “qualified” or “non-qualified” in the eyes of the IRS. A qualified annuity is purchased with money from a pre-tax or tax-deferred account like an IRA. Withdrawals are then made at ordinary income tax rates.
Conversely, a non-qualified annuity is purchased with money that comes from a taxable bank or brokerage account. Only earnings will be taxed.
The term of the annuity — period or lifetime — also plays a factor. A period annuity comes with a set term length whereas a lifetime annuity is what it implies — a regular amount dispersed over someone’s lifetime. Early payouts and lump-sum distributions are taxed at ordinary income tax rate instead of the benefit of capital gains.
Read more information and tips in our Taxes section