Taxes might significantly reduce your retirement income. The greater your retirement income, the greater your tax liability, and this causes a greater proportion of your hard-earned money to be utilized to pay taxes. Continue reading to see how different types of retirement income are taxed.
Taxes will generally be lower for retirees than when they were working, and this does not mean that seeing your tax bill in retirement will not be distressing each time you must write a check to the IRS and state tax authorities.
With some proactive tax planning, you can dramatically lower the taxes you will owe on your retirement income. You may be able to improve your tax-free income in retirement.
Social Security Income Taxes
Approximately half of Social Security recipients owe federal income taxes on this portion of their retirement incomes each year. Social Security benefits become taxable. This barrier will increase once you earn more than a certain amount of $25,000 for single filers and $32,000 for married filers in 2024. 50% of your Social Security benefits are considered taxable income.
In 2024, 85% of Social Security benefits will be taxed for recipients with incomes exceeding $34,000 (single) and $44,000 (married filing jointly). I must also note that these criteria are not adjusted for inflation, so I anticipate that a greater portion of your Social Security income will be taxable over time.
Nontaxable Retirement Income
Consider this a withdrawal from your Individual Retirement Account, 401(k), 403(b), 457, or Cash Balance Pension Plan. Contributions to these plans were excluded from your taxable income, and the IRS intends to collect taxes when withdrawals are made.
Your withdrawals will be subject to the tax brackets during the withdrawal year. The more your annual retirement income, the more taxes you will likely owe. The highest federal tax bracket is now 37%, and California’s highest state tax bracket has a rate of 13.3%.
Income From Annuities in Retirement
How your income is taxed on an annuity depends on how the account is titled. The withdrawal will be taxed as normal income if you possess an annuity within your IRA. If you own a Non-Qualified Annuity, you will first withdraw your “earnings,” which will be taxed as ordinary income. Once you have exhausted your profits, you will remove your cost basis, which is exempt from taxation.
If you possess a non-qualified annuity, you should collaborate with your tax-planning financial advisor to devise a strategy for withdrawing funds as tax-efficiently as possible over time. If you have an older annuity, consider a 1035 exchange to a new fee-only annuity with lower fees. Over time, you could save a lot of money because of the decline in annuity fees.
Roth IRA Pension Income
Having a variety of taxation options for your retirement income is generally advantageous. Having assets in a Roth IRA could reduce the amount of taxes due on retirement income. Roth IRAs and Roth 401(k)s are funded with after-tax earnings, so retirement withdrawal may be tax-free.
The longer you have until you need to take your funds, the greater the tax advantages of a Roth IRA might be.
Remember Medicare Surcharges
Reminder, enrolling in Medicare does not mean Uncle Sam will cover all your premiums and medical expenses. For seniors with higher incomes, Medicare Part B (covering outpatient services) and Part D premiums will incur additional fees (covering prescription drugs). This may be called IRMAA (Income-Related Monthly Adjustment Amounts), which can substantially raise your Medicare premiums.
Taxes on the States
The state taxes you owe in retirement depend on your residence and retirement income. Ensure that you are aware of state taxes.
Strategies for Tax Planning on Retirement Income
Before retirement, proactive tax preparation can help you lower your overall tax burden. It can also prevent you from being surprised by how much of your budget taxes and Medicare surcharges you consume. In addition to 401(k)s and other accounts from which withdrawals are completely taxable and subject to RMDs, it is necessary to diversify your holdings (RMDs).
An option is to contribute to a Roth IRA or a Roth 401(k). You may also wish to explore a Roth conversion early in retirement, especially if your tax bracket is lower now than it would be later.
Investing in health savings accounts (HSAs) can be a terrific method to generate tax-free retirement income for medical costs or even medical premiums.
Additionally, keeping a portion of your retirement funds in a taxable investing account is frequently advantageous. This permits the taxation of income as capital gains. With proper tax preparation, you may be able to preserve a substantial portion of this investment income in the 0% capital gains tax band, resulting in tax-free withdrawals.