Many people look forward to a time when they no longer have to work (at least, actively) to earn money.
It is exciting to think of a phase of life where you have time freedom, where you no longer have to deal with tight schedules or a boss breathing down your neck, and when you can travel at will around the world.
However, all of that could be significantly marred if you don’t factor in tax implications and plan accordingly. Depending on how much income you get in retirement, income taxes can be your single largest expense.
Keep reading to learn everything you need to know about retiree tax.
Do Retirement Incomes Get Taxed?
Yes, retirement incomes are taxable.
But paying taxes on your retirement income depends on the total retirement income you and your spouse get. Your tax bill will also be different if you are filling joint or separate tax turns.
Generally, you can expect to pay taxes on part of your Social Security, pension income, and other retirement accounts.
How Social Security Is Taxed
It may come as a surprise but up to 85% of your benefits from Social Security are taxable.
But don’t panic just yet. This will depend on your filing status and overall retirement income.
You probably won’t owe any taxes if your only source of income in retirement is Social Security. Retirement taxes should start to be of major concern to you if you have other sources of income in addition to Social Security (which, hopefully, you have).
Typically, the higher your total income in retirement is, the bigger the taxable part of your Social Security benefits.
In other words, what you pay in taxes on Social Security benefits depends on:
Tax-exempt interest income: This includes interests or income that you get from municipal bonds issued by states or cities.
Adjusted Gross Income (AGI): Your AGI is the amount of money you have left when you subtract exclusions and deductions from your gross or total income. The total income is made up of dividends, pensions, annuities, interests, 401(k), and IRA distributions, among others. These
More specifically, here is a summary of how retiree tax works on Social Security benefits.
You won’t have to pay taxes on your Social Security benefits if your total income in retirement does not exceed $24,999 (filing as an individual) or $31,999 (filing jointly with a spouse).
Up to 50% of your Social Security benefits may be taxable if your total income ranges between $25,000 and $34,000 as an individual or $32,000 to $44,000 for married couples filing jointly.
Up to 85% of your benefits from Social Security may be taxed if your total income in retirement is more than $34,000 as an individual.
Up to 85% of your Social Security benefits may be taxed if your overall retirement income is more than $44,000 as a married couple filing jointly.
Married people who file separate tax returns won’t get any tax breaks. That is to say, up to 85% of their Social Security benefits may be taxable.
How Much Income Can You Get Without Getting Taxed as a Retiree?
How much income tax you pay will depend on your total income and the different sources of your income.
The possible income sources in retirement are:
Distributions from retirement accounts, such as 401(k) and IRA
Social Security benefits
Income from self-employment or as an employee (after retirement)
The Internal Revenue Service (IRS) classifies all of these different sources into two distinct income types, which are earned and unearned income.
How Earned Income Is Taxed
Earned income refers to money you earn from employment. This is typically applicable to retirees who choose to continue working in retirement.
So, if you’ve ever asked, “Do I have to pay taxes on income from my retiree job?” The answer is yes! Such earnings are taxable, regardless of whether you work as an employee or pursue self-employment.
In other words, the money you earn from your retiree job is subject to Medicare, Social Security, and income taxes.
How Unearned Income Is Taxed
In simple terms, unearned income refers to money you get from investments and sources that have nothing to do with employment. Examples include:
However, just because they are classified as “unearned” doesn’t mean they are completely exempt from taxes.
However, the income tax is subject to the various rules that guide the different sources of income. In any case, the exact amount you will pay in taxes will depend on the tax bracket your total taxable income falls under in retirement.
Typically, distributions from your 401(k) account are taxable because the account is funded with before-tax contributions.
Also, distributions from a traditional IRA may be taxable if you claimed tax deductions for your contributions. Once you start taking money out of this account, you owe taxes at your regular income tax rate on the earnings of the withdrawals.
Similarly, you owe tax at the same rate if you deducted any amount from your contributions. Equally, your income from an employer-funded pension plan is also taxable. However, the taxes you pay will depend on the total of all your income in retirement.
In a nutshell, both earned and unearned incomes are taxed as ordinary income at varying rates. However, if your IRAs and other qualified retirement accounts are funded with after-tax contributions, distributions from these accounts will not be taxed. That’s because you did not claim tax deductions for those contributions in the first place.
Lastly, distributions from certain types of accounts are not taxable. Typical examples include distributions from Roth 401(k) and Roth IRA.
How Other Retirement Incomes Are Taxed
If you have an IRA, 401(k), or other similar employer-sponsored plans, you are required to start withdrawing a certain minimum amount of money every year. This is known as Required Minimum Distribution (RMD).
RMDs are considered income and they are taxable and you are required to make these withdrawals when you turn age 72 (or 70½ if you were born before July 1, 1949).
It is important to mention that you won’t have to pay taxes on RMD if you own a Roth plan funded with after-tax dollars. That’s because there is no RMD requirement for this type of account.
Also, the earning portions of your Roth plans are not taxable. But you must operate the account for a minimum of five years to qualify for the tax-free provisions on interests and earnings.
Do I Need an Accountant?
Older people may have a difficult time tracking all their taxable incomes.
That’s because many seniors have several earned and unearned incomes that are subject to different tax rules.
You may not need the services of a tax accountant if you have always stayed on top of filing your tax returns during your active working years.
However, seniors who dread filing their taxes will need to hire a professional to help them out.
How a Tax Accountant Can Help You
Typically, a tax accountant will help you determine the best tax strategies that can minimize, defer, or eliminate tax payments.
A tax accountant can help you lower your tax burden in the following specific ways:
Using capital loss to offset capital gains
Advising you on how to give huge cash gifts to several people without owing federal gift tax
Avoiding capital gains when gifting assets that have increased in value and enjoying tax deductions at the current value.
Guiding you on the best ways to direct your RMD to qualified charities, especially if you have no use for the money.
With a tax accountant’s help, you will be able to avoid errors from incorrect tax fillings. No matter how complex a tax issue gets, a professional tax accountant will be able to find a legitimate win-win solution for you.
Consider hiring a tax accountant if you have difficulty wrapping your head around all the different tax rules.
You will likely pay taxes in retirement unless your income is below the yearly standard deduction level.
However, the exact amount you will pay in taxes depends on several factors, including the specific tax year, your total income in retirement, and whether you are filing single or jointly with a spouse.
In some cases, you can prepare your taxes yourself. But if you don’t fully understand the ins and outs of retiree tax, it is best to seek the help of a tax accountant. The professional can also suggest suitable strategies for reducing your tax burden.
John E Chambers is an experienced financial advice expert. Born in Chicago, he has a master's in Industrial Finance, but he has spent decades offering investment advice to businesses and individuals alike. He is the founder of RetireeWorkforce.com and wants the website to be valuable for retirement advice. In addition, he writes articles that help users jump-start their retirement plans and choose the best investment options. If not pondering over stock market statistics or reading some magazines, you can find John spending time with his family. As an early retiree, John also offers unique insights into what post-retirement life is like.