Taxes in Retirement – How Can You Get More from Your Money
Taxes can have an impact on you throughout most of your life. That’s because tax is often due on the purchases that you make, as well as on the income you earn and on the profit that you make from various investments. In many cases, taxes are even due on the assets of a person who dies.So, it stands to reason that taxes will likely be present on the income that you receive when you retire. But to what extent could Uncle Sam reduce your net spendable retirement income? The answer has to do with how much retirement income you receive and where that income is generated from.
How Much Can Taxes Impact Your Net Spendable Income in Retirement?
Most retirees receive income from more than just one source. These lifetime income generators could include one or more of the following:
- Social Security
- Employer-sponsored pension
- Dividends and/or interest from personal investments
- Annuity
In some cases, this income will be subject to federal income tax and possibly state income tax, too. Unfortunately, nobody knows what income tax rates will be in the future. So, it can be difficult to determine exactly how much you will owe.Over the past century or so, the amount of the top Federal income tax rate has fluctuated a great deal, from a low of just 7% to a high of 94%. In fact, just since the year 1913, this rate has been in excess of 70% forty-nine times.So, if your retirement income is affected, would you be able to live on less than half of what you bring in from your investments and other income generators?
Top Federal Income Tax Rates 1913 – 2021
YearRateYearRate2018-202137195084.362013-201739.61948-194982.132003-2012351946-194786.45200238.61944-194594200139.11942-1943881993-200039.61941811991-199231194081.11988-1990281936-193979198738.51932-1935631982-1986501930-193125198169.1251929241971-1980701925-192825197071.75192446196977192343.5196875.251922581965-1967701919-1921731964771918771954-1963911917671952-1953921916151951911913-19157Source: Inside Gov
Which Retirement Income Generation Sources are Taxable?
Some – or even all – of the guaranteed retirement income that you generate may be taxable. For instance, if you contributed money into various savings plans on a pre-tax basis – and the gains in the account(s) were also tax-deferred – then none of this income has been subject to income tax yet. Therefore, 100% of the withdrawals from these plans will be taxable.Typically, the following retirement income sources will be taxed to some extent:
- Pension income
- Tax-deferred investments (such as traditional IRAs, traditional 401k plans, traditional 401b plans)
- Gains/profits from personal savings and investments
- Income from a personal annuity (in this case, the portion of the income that represents any gain will be taxable, and the portion that represents a return of your principal will be tax-free)
- Income from a qualified annuity (oftentimes, funds from a traditional IRA and/or employer-sponsored retirement plan will be rolled into an annuity. If none of these funds have been subject to tax yet, then 100% of the withdrawals will be taxable as ordinary income at the then-current rates)
You may be surprised to learn that some of your Social Security retirement income could also be taxable. This is typically the case if you have other “substantial” income – such as wages from a part- or full-time job, dividends and/or interest from investments, and/or other funds that need to be reported on your annual tax return – in addition to your Social Security retirement benefits.The amount that your Social Security benefits are taxed will depend on a couple of key factors, including the:
- Amount of other income you receive
- The way you file your income tax return
Social Security uses a figure that is referred to as your “combined income” to determine how much of your benefits will be taxable (if any). Your combined income is determined by taking your adjusted gross income and adding any non-taxable interest and one-half of your Social Security benefits.
Adjusted Gross Income+Non-taxable Interest+ of your Social Security benefits=Combined Income
As an example, in 2021, if you file your federal income tax return as an individual, and your combined income is:
- Between $25,000 and $34,000, you may have to pay income tax on up to 50% of your benefits
- More than $34,000, then up to 85% of your Social Security benefits may be subject to federal income tax
If you instead file a joint income tax return, and you and your spouse have combined income, that is:
- Between $32,000 and $44,000, you may incur federal income tax on up to 50% of your Social Security retirement benefits
- More than $44,000, then up to 85% of your benefits could be taxable
The rate of income tax that is due on your retirement income will depend on the amount of income you earn and how you file your federal income tax return (such as individual, head of household, married filing jointly, qualifying widow, or married filing separately.
2021 Income Tax Brackets and Rates
RateUnmarried IndividualsMarried Individuals Filing JointlyHead of Household10%Up to $9,950Up to $19,900Up to $14,20012%$9,951 to $40,525$19,901 to $81,050$14,201 to $54,20022%$40,526 to $86,375$81,051 to $172,750$54,201 to $86,35024%$86,376 to $164,925$172,751 to $329,850$86,351 to $164,90032%$164,926 to $209,425$329,851 to $418,850$64,901 to $209,40035%$209,426 to $523,600$418,851 to $628,300$209,401 to $523,60037%Over $523,600Over $628,300Over $523,600Source: Internal Revenue ServiceShort-term capital gains tax rates on most assets that are held for less than one year correspond to ordinary income tax rates. However, long-term capital gains tax rates, which apply to assets held for more than one year, are also dependent on the amount of income you earn in a given year and how you file your tax return.
Long-Term Capital Gains Tax Rates (in 2021)
Tax RateSingleHead of HouseholdMarried Filing JointlyMarried Filing Separately0%$0 $40,000$0 $54,100$0 $80,000$0 $40,00015%$40,001 $445,850$54,101 $473,750$80,001 $501,600$40,001 $250,80020%$445,851 or more$473,751 or more$501,601 or more$250,801 or moreSource: IRS.govUse this long-term capital gains calculator to estimate your after-tax investment gains, and in turn, the amount of tax you may owe.In addition to federal income tax, you could also be subject to state income taxes. In fact, only Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming levy no personal income tax (in 2020). Two other states – New Hampshire and Tennessee – do not tax wages (but they do tax investment income and interest).There are 12 states that tax Social Security benefits (in 2020). These are:
- Connecticut
- Kansas
- Minnesota
- Missouri
- Montana
- Nebraska
- New Mexico
- North Dakota
- Rhode Island
- Utah
- Vermont
- West Virginia
How to Reduce – or Even Eliminate – the Amount of Income Tax You’re Subject to in Retirement
Because nobody knows what income tax rates will be in the future, it is wise to plan ahead so that you can reduce as much income as possible that is exposed to taxation. One tax-reduction strategy is to take advantage of the Roth IRA.While the contributions that go into a Roth account have already been subject to tax, the gains in the account are tax-free, as are the withdrawals. This is the case, regardless of what the then-current income tax rates are.The maximum annual contribution to a Roth IRA (in 2021) is $6,000 for those aged 49 and younger and $7,000 for those aged 50 and over. It is also possible to roll funds from a traditional IRA or retirement account into a Roth IRA. Although the transaction will be taxable at that time, it could end up saving you a great deal of tax liability in the future when you make your withdrawals.There are some income limits that apply, though, so not everyone will qualify to open a Roth IRA. However, there are also some strategies available that can still allow higher-income earners to fund this type of tax-advantaged IRA.Discussing your particular situation and objectives with a retirement financial advisor can help you to move more easily through the process. If you have any questions regarding retirement income taxation or looking for strategies to reduce your income tax liability in the future, please contact us directly and speak with an income specialist. We can be reached at [email protected]. We look forward to assisting you.
