Taxes don't end when you stop working. Federal and state tax issues come into play in several retirement income areas.
The key focus of all retirement plans is ensuring you have enough money to live the retirement lifestyle you want. While you were working, you took advantage of workplace savings accounts such as 401(k) plans and individual retirement accounts.
If your IRA is a Roth account, you don't have to worry about tax issues with the Internal Revenue Service. You paid taxes on the money before you put it into your Roth IRA, and its earnings have grown tax-free. That means you don't owe the IRS anything on your withdrawals once you retire.
But if you're depending on traditional IRA or 401(k) funds, you will owe taxes. You never paid income taxes on the workplace plan or deductible IRA contributions. Plus, the earnings of these accounts are tax-deferred, meaning you owe tax at your ordinary income tax rate on money you take out in retirement.
And if you've delayed distributions so as to postpone those taxes for as long as possible, remember that the required minimum distribution, or RMD, rules compel you to withdraw certain amounts when you turn 70 ½. The IRS has life-expectancy charts, the most common one being the Uniform Lifetime Table, that help you calculate how much to withdraw.
Traditional IRA, 401(k) withdrawal rules
- Withdrawals are required from all tax-deferred retirement accounts once you turn 70 ½.
- The account distributions are taxed at ordinary income tax rates.
- If you made nondeductible contributions to a traditional IRA, information on IRS Form 8606 you filed reporting those contributions will help you avoid paying taxes on that money again when you withdraw it.
- The IRS has three required minimum distribution tables to help you figure the amount to withdraw. Basically, the longer you are expected to live, the less the IRS requires you to withdraw, and pay taxes on, each year.
Taxable Social Security
Your private retirement accounts are designed to supplement your Social Security benefits.
But your added retirement income, whether from an IRA or pension plan, investment income or a job (including self-employment), could lead to taxes on at least part of your government benefits.
Retirees could pay taxes on up to 85 percent of Social Security benefits, says Mike Piershale, a Chartered Financial Consultant and president of Piershale Financial Group in Crystal Lake, Ill.
Just how much tax depends on your provisional income. "Three items are considered: your adjusted gross income, plus one-half of Social Security, plus tax-free income," says Piershale.
When the sum of those amounts exceeds $34,000 ($44,000 if you are married filing jointly), then you'll owe tax on the benefits. "If you're receiving $10,000 in Social Security, $8,500 could be taxed," says Piershale.
If you're in the 15 percent tax bracket, that $8,500 in taxable Social Security would mean you owe the IRS $1,275.
Taxable Social Security tip
If you owe taxes on your federal retirement benefits, you can either make estimated tax payments or have the tax withheld from your regular benefit checks. You can choose to have 7 percent, 10 percent, 15 percent or 25 percent withheld. To authorize the withholding, file Form W-4V, Voluntary Withholding Request, with the Social Security Administration.
Investment tax issues
In addition to Social Security and tax-advantaged retirement savings accounts, many retirees also depend on other investments for their retirement income. And some of those earnings could produce new tax concerns in retirement.
As noted by Piershale, tax-free income is a factor in determining how much Social Security is taxable. That means a common investment used to avoid paying Uncle Sam -- tax-free interest from municipal bonds -- could be a problem in retirement.
So a first step as you near or enter retirement is to reevaluate your portfolio.
Piershale says many of his clients opt to bring down their provisional income by putting money into such tax-sheltered accounts as annuities that don't count toward the taxable Social Security formula.
Location tax considerations
Many retirees relocate, either to be closer to their families, take advantage of more comfortable climates and, yes, to escape taxes.
The conventional wisdom is to head to a no-income-tax state. But take a few minutes to evaluate all the possible tax issues in a state before you load up the moving van.
"People are often attracted to a state with no personal income tax thinking that will get them a better tax answer," says tax attorney Kathleen Thies, state tax analyst for CCH, a tax software and publishing company in Chicago.
"States are a business," says Thies. "Every state needs to make a certain amount of revenue to run, and if it doesn't have an income tax, it's raising the money somehow. It could have higher sales or property taxes."
Thies also cautions retirees to establish residency in one state. "If you're getting ready to retire to another state, be careful not to put yourself in a position where you could be taxed in two places," she says.
Get a driver's license in your new state, and make sure mail is sent to your new home. "You want significant ties to the state to suggest you changed your domicile for tax purposes," says Thies. Without that proof, your former state might still try to collect taxes from you, or you might not qualify for tax breaks in your new state.
States that tax at least a portion of Social Security benefits:
- Rhode Island
- West Virginia
- New Mexico
- North Dakota
And while most states don't tax Social Security benefits, most do tax at least a portion of other retirement income, such as pensions. Double-check with the state tax office where you plan to move for details so that you don't face a costly surprise at tax time.