I recently spoke with a prospective client who was adamant that he would not have to pay taxes in retirement. He read and printed an online article which indicated, “You will not owe these taxes in retirement.” That myth was reinforced when his employer’s human resources associate person told him that he would not have to pay payroll taxes in retirement. Did you catch that? He was told he would not owe payroll taxes during his retirement years, which he misunderstood and thought he would not owe any taxes once he retired. Assuming you have income in retirement, you will be subject to at least some income taxes in your golden years.
This was a successful executive with a huge income before retirement. He was confusing taxes taken from his paycheck with only the payroll taxes. While it is true you won’t have to pay Social Security and Medicare taxes on withdrawals from retirement accounts, you will still be subject to income taxes at the state and federal levels. In his case, what began as a great retirement income was not looking so comfortable after taxes were taken into account. He went from expecting around $200,000 to spend in retirement to something closer to $140,000, or so, after taxes. That is still a nice income but 30% less than he expected. Side, not bigger problem, he was currently making over $500,000 per year, and spending a vast majority of his take home pay.
What Taxes Will You Owe in Retirement?
The good news is that income from a retirement account is generally worth more than income from working. Once retired and living on unearned income, you will no longer be paying Social Security and Medicare payroll taxes. You will still be subject to income taxes at the federal state levels. That assumes you don’t live in a state without an income tax.
Currently, federal income tax rates range from 10 to 37 percent, depending on your income level and marital status. Expect to get hit with taxes on your retirement income from things like a pension, annuity, IRA, 401(k), defined benefit plan, 457, or other pre-tax retirement accounts.
Tax-Free Income in Retirement
If you have money in a Roth, Roth 401(k), or the Rich Person Roth , you will have some tax-free retirement income. While that is a great piece of a well-rounded retirement plan, few people have all of their assets in Roth accounts. If they do, they have not accumulated enough assets to fully fund a comfortable retirement. Most people will still have some income in taxable accounts, or accounts like a 401(k), which will be taxed when funds are withdrawn.
Will Social Security be Taxable in Retirement?
An estimated 60% of retirees will not owe federal income taxes on their Social Security benefits. That is likely why many people believe Social Security benefits are tax-free. However, they are not. What this actually means is that a majority of retired people are living on a relatively small income.
How much of your Social Security benefits will be taxed will ultimately depend on how you derive your retirement income and how much of it you will be receiving each year, as well as which state your live in. That will be a combination of all other earnings in a given year, plus some portion of your Social Security benefits. Other earning sources include things like distributions from your 401(k) or IRA, wages from work, pensions, royalties or even rental income.
Retirement will not get you out of paying sales taxes. While the amount you will pay depends on your shopping habits and state of residence, it is something that can’t be ignored. Similarly, homeowners will still be subject to property taxes. For many retirees, property taxes can be one of their largest expenses. If you choose to itemize your deductions, property taxes could help to reduce your income taxes.
Medicare Surtax Still Applies in Retirement
You may have heard it called the Medicare Surtax or Obamacare Surtax. Officially, it is known as the Unearned Income Medicare Contribution Surtax, NIIT. It is a 3.8% Medicare tax that applies to income from investments and regular income above specific thresholds. For 2020, if you have Modified Adjusted Gross Income (MAGI) above $200,000 ($250,000 for married couples filing jointly), you will be subject to NIIT. I mention this because it is typically a surprise to many people when filing their taxes. It can also add up quickly, especially when people have great stock market returns and realized gains, paired with a nice income.
With proper financial planning, you will be able to replace 100% (or more) of your pre-retirement income. In many cases, it could mean paying similar amounts of taxes in retirement as you did while working. That wouldn’t be the end of the world, but it’s something you need to be aware of. Bottom line, if you do a good job saving and have a large income in retirement, you will most likely end up paying at least some income taxes on your retirement income. Good news, some amazing tax planning can help keep these tax bills to a minimum, essentially giving your retirement income stream a raise.
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