49% of Americans have planned and saved to have enough money to live through their retirement. However, one of the most important steps in planning by estimating retirement expenses is often overlooked: taxes.
Taxes can be a burden while you are working, but they can be even more of an unpleasant surprise in retirement. While many people anticipate that their income will decrease when they stop working, this is not always the case. Some people actually see their income, and therefore their taxes increase during retirement. Others haven’t planned for the increases in taxes all Americans might see in the future. The Tax Cut and Jobs Act of 2017 lowered taxes for now, but this period of light taxation won’t last, and those preparing for retirement should be prepared for the inevitable increases after the eight-year period created by the Act ends. As soon as that period runs out in January of 2026, taxes are anticipated to increase yet again.
There are numerous reasons why your tax estimates for retirement may be off.
Social Security benefits you receive in retirement may be taxed much more than anticipated if you’ve generated a substantial investment income, if you have a solid pension, or if you decide to go back to work part-time. You may end up receiving much less than expected, so it’s important to understand how the type of account your retirement income is coming out of affects the rate of taxation you will experience.
Traditional IRAs and Traditional 401(k)s
These accounts are funded with pre-tax dollars, so when you take this money out as retirement income down the road, it will be subject to the taxation policies at that time. This may be a great option for those who anticipate being in a lower tax bracket after retirement, but for the many people who end up being in a higher tax bracket than expected, these accounts can represent a huge amount of taxable income.
Social Security Benefits
These benefits are taxable if one-half of your Social Security benefits plus all of your other income exceeds a certain base amount on your filing status.
Note: ‘all of your other income’ includes taxable pensions, wages, investments, and all other taxable income. It also includes tax-exempt interest income plus normally excludable income such as interest from Series EE savings bonds and foreign-earned income.
If your Social Security benefits are taxable, either up to 50 percent or up to 85 percent of your benefits will be taxed. The taxation percentage depends on your filing status and the amount by which you exceed the base figure. For example, if you file jointly, your provisional income, or your Social Security Benefits plus all of your other income, exceeds $44,000, up to 85% of your Social Security will be subject to taxation at the federal level. 13 states collect taxes on this income as well, so be wary of the state in which you choose to retire as well.
Your pension may also be taxable. Pensions vary depending on the employer, but generally, pensions that aren’t military- or disability-related will be taxed.
One option you have to help minimize your taxes in retirement is to have various income options. Various income streams provide the flexibility to re-strategize in changing conditions to minimize how your income will be taxed. With anticipated increases to future taxes, it is especially important to consider what your non-taxable income options are.
One example of a non-taxable income option is a Roth IRA. When you contribute to a Roth IRA, you pay tax at the time you invest. By paying taxes upfront, contributions and earnings become tax-free when they are withdrawn in retirement. These tax-free withdrawals also apply to beneficiaries who may eventually inherit your Roth IRA. There are income limits that will exclude some people from being eligible, but you may be able to modify your eligibility if you do a Roth Conversion with other retirement account assets.
Similar to a Roth IRA, there are also Roth 401(k) or 403 (B) accounts. If your plan allows it, these can be excellent options to diversify your income streams. Like a Roth IRA, you’re pre-paying tax on contributions, so withdrawals on both contributions and earnings in retirement are tax-free. Unlike the Roth IRA, Roth 401(k) and 403 (B) accounts don’t have income eligibility limits. In this plan, contributions are taken from paychecks before tax is deducted, so you have to pay tax on those contributions at the end of the year. Paying tax while you’re still working rather than in retirement can be beneficial because of the deduction possibilities available while you’re working. For example, it’s much more likely you can claim a dependent during your working years than in retirement.
When planning to for retirement, there is no one-size-fits-all solution. Work with a financial professional to analyze what your tax burdens might look like in retirement. If you believe your your retirement plan is setting you up for high taxes in retirement and are concerned about your plan, give us a call at (716) 906-8121.