Retirement is a major life event that brings many changes, not only in your lifestyle, but also in your finances. One of the most important aspects of retirement planning is understanding how retirement taxes work and how they affect your income and expenses. Retirement taxes are more intricate compared to taxes during your working years, necessitating an understanding of various income types and their corresponding tax implications.
In this article, we will explain how retirement taxes work, how different types of retirement income are taxed, and what strategies you can use to minimize your tax liabilities. By the end of this article, you will have a better grasp of the complexity of retirement taxes and how to plan accordingly.
Tax Changes in Retirement
One of the first things you need to know about retirement taxes is that they are not the same as taxes during your working years. Upon retirement, certain taxes like payroll taxes (FICA) cease to apply, which includes Social Security and Medicare taxes. However, federal and potentially state taxes still apply, albeit with different rates and rules.
The amount of federal and state taxes you pay in retirement depends on several factors, such as:
- The amount and sources of your retirement income
- The deductions and credits you are eligible for
- The tax brackets and rates that apply to your income level
- The state and local tax laws where you live
Generally speaking, the more income you have in retirement, the higher your tax bill will be. However, not all types of retirement income are taxed the same way, which leads us to the next section.
Ordinary Income vs. Capital Gains
One of the key distinctions you need to make when it comes to retirement taxes is between ordinary income and capital gains. Ordinary income is income that is taxed at your regular income tax rate, which can range from 10% to 37% in 2024, depending on your income level and filing status. Capital gains are profits from selling assets that you have held for more than a year, such as stocks, bonds, or real estate. Capital gains are taxed at a lower rate than ordinary income, which can be 0%, 15%, or 20%, depending on your income level and filing status.
Why is this distinction important? Because it affects how different types of retirement income are taxed. Let’s look at some of the most common sources of retirement income and how they are taxed.
Taxation of Common Retirement Incomes
Social Security Income
Social Security income is one of the most prevalent sources of retirement income, but it is also one of the most complex when it comes to taxation. Social Security income is subject to federal taxes based on a certain percentage of your benefit, which can be 0%, 50%, or 85%, depending on your provisional income. Provisional income is your adjusted gross income (AGI) plus half of your Social Security benefit plus any tax-exempt interest. The higher your provisional income, the higher the percentage of your Social Security benefit that is taxable.
For example, in 2024, if you are single and your provisional income is less than $25,000, none of your Social Security benefit is taxable. If your provisional income is between $25,000 and $34,000, 50% of your benefit is taxable. If your provisional income is more than $34,000, 85% of your benefit is taxable. The thresholds are higher for married couples filing jointly.
In addition to federal taxes, some states also tax Social Security income, either partially or fully, while others do not. You can check the tax rules of your state here.
Pension Income
Pension income is another common source of retirement income, especially for those who worked in the public sector or for large corporations. Pension income is generally taxed as ordinary income at the federal level, unless you made after-tax contributions to your pension plan, in which case you can exclude a portion of your benefit from taxation. You can use this worksheet to calculate the taxable amount of your pension income.
Similar to Social Security income, some states also tax pension income, either partially or fully, while others do not.
Interest Income
Interest income is income that you earn from savings accounts, certificates of deposit (CDs), bonds, or other fixed-income investments. Interest income is generally taxed as ordinary income at the federal level, unless the interest is from tax-exempt sources, such as municipal bonds or U.S. savings bonds. Tax-exempt interest is not subject to federal taxes, but it may be subject to state or local taxes, depending on where you live.
Dividend Income
Dividend income is income that you receive from owning shares of stocks, mutual funds, exchange-traded funds (ETFs), or other equity investments. Dividend income can be either qualified or non-qualified, depending on how long you have held the shares and the type of company that pays the dividends. Qualified dividends are dividends that meet certain criteria, such as being paid by a U.S. corporation or a foreign corporation that is eligible for tax treaty benefits. Qualified dividends are taxed at the same rate as long-term capital gains, which can be 0%, 15%, or 20%, depending on your income level and filing status. Non-qualified dividends are dividends that do not meet the criteria for qualified dividends, and they are taxed as ordinary income at your regular income tax rate.
Strategies to Minimize Taxes
As you can see, retirement taxes can be quite complicated and vary depending on your income sources and tax situation. However, there are some strategies that you can use to minimize your tax liabilities and keep more of your hard-earned money in retirement. Here are some of them:
- Understand your provisional income for Social Security. As we mentioned earlier, your provisional income determines how much of your Social Security benefit is taxable. By keeping your provisional income below the thresholds, you can reduce or eliminate the taxation of your Social Security income. You can do this by reducing your AGI, which can be achieved by deferring income, taking deductions, or making tax-free withdrawals from Roth accounts.
- Utilize tax-free municipal bonds. Municipal bonds are bonds issued by state or local governments to fund public projects, such as roads, schools, or hospitals. The interest income from municipal bonds is generally exempt from federal taxes, and sometimes from state and local taxes as well, depending on where you live and where the bond is issued. By investing in municipal bonds, you can generate tax-free income that does not affect your provisional income for Social Security or your AGI for other tax purposes.
- Consider Roth conversions or qualified charitable distributions. Roth conversions are transactions where you convert some or all of your pre-tax retirement accounts, such as traditional IRAs or 401(k)s, into Roth accounts, which are post-tax retirement accounts. By doing so, you pay taxes on the converted amount in the year of the conversion, but you avoid paying taxes on the future withdrawals from the Roth accounts. This can lower your taxable income in retirement and reduce the taxation of your Social Security income. However, Roth conversions are not for everyone, as they can increase your tax bill in the year of the conversion and affect your eligibility for certain tax benefits. You should consult a tax professional before deciding whether to do a Roth conversion.
Qualified charitable distributions are distributions that you make directly from your traditional IRA to a qualified charity, up to $100,000 per year, after you reach age 70 1/2. By doing so, you can satisfy your required minimum distribution (RMD) without adding to your taxable income. This can lower your AGI and your provisional income for Social Security, as well as reduce your tax bill and support a good cause.
- Be mindful of net investment income tax and income thresholds for surcharges. Net investment income tax is an additional 3.8% tax that applies to certain types of investment income, such as interest, dividends, capital gains, rents, royalties, and annuities, if your modified adjusted gross income (MAGI) exceeds certain thresholds. The thresholds are $200,000 for single filers and $250,000 for married couples filing jointly. By keeping your MAGI below these thresholds, you can avoid paying this extra tax on your investment income.
Income thresholds for surcharges are the income levels that trigger higher premiums for Medicare Part B and Part D, which cover medical services and prescription drugs, respectively. The higher your income, the higher your premiums. The income thresholds are based on your MAGI from two years ago. For example, in 2024, your premiums are based on your MAGI from 2022. By keeping your MAGI below the income thresholds, you can avoid paying higher premiums for Medicare.
Conclusion
Retirement taxes are a complex and important topic that can have a significant impact on your retirement income and expenses. By understanding how retirement taxes work, how different types of retirement income are taxed, and what strategies you can use to minimize your tax liabilities, you can plan ahead and optimize your retirement finances. Remember, this article is for informational purposes only and does not constitute tax advice. You should consult a tax professional for your specific tax situation and needs.