When you retire, taxes can affect your disposable income and leave you with little or nothing to live on. It's essential to remember that taxes don't stop after retirement, but there are steps you can take during your working life to minimize your IRS obligations later.
Understanding the tax rules that apply to retirees is also important for young Americans, as many decisions to reduce the future tax burden must be made in advance. This guide will explain the tax rules for regular sources of retirement income and give you some retirement planning tips that can reduce your tax liability.
How to determine the tax bracket in retirement
Determining the retirement tax bracket is like determining the pre-retirement tax bracket, as the same basic brackets apply to retirees that apply to all taxpayers. The group you are in is determined by your filing status and your taxable income (income minus deductions).
Common sources of taxable income that are taxable include:
Certain retirement income
Distributions of traditional 401(k) and IRA accounts
Income from work (full-time or part-time)
Investment Income
Social security benefits (in some cases)
Once you have determined your taxable income, consult a table of tax brackets to determine your rate based on the status of your tax return.
However, the difficult thing is that rates can change over time as they adjust for inflation or tax reform legislation. Therefore, if retirement is still a long way off, it can be difficult to predict your future retirement rate. However, if you can estimate your future retirement income, you can get a rough idea of your tax category, barring major legislative changes.
How to minimize taxes in retirement
These are some steps to minimize the taxes you will pay as a retiree. Here are five techniques to try:
Invest in Roth accounts
Roth 401(k) and Roth IRA distributions are not taxable upon retirement. You can withdraw from a Roth account without paying taxes, as long as you follow the IRS withdrawal rules.
If you don't want to be bothered about paying taxes after retirement, use these accounts as your primary way to save for retirement. Or, invest at least some of your retirement money during your working life to reduce your future tax bill.
However, please note that Roth accounts do not offer tax exemptions upfront in the year you make your contributions. Therefore, it makes sense to choose Roth over traditional accounts if you expect your tax bracket will be higher during retirement than during the years you contribute to retirement accounts.
Traditional accounts can be converted to Roth accounts. However, there are always tax consequences, and a five-year rule can limit your ability to access tax-free funds if you move your account too close to retirement.
Live in a tax-free state.
Some states have more tax-efficient policies than others. Nine states tax no income, while others do not tax Social Security.
Because your geographic location isn't limited to your post-retirement job, it can pay off to move to a location where you no longer owe the state government taxes.
Make strategic withdrawals
After you reach age 72, you should start taking the Required Minimum Distributions (RMD) from certain tax-advantaged retirement accounts, such as IRA and 401(k). The value of your distributions is based on factors such as age and account balance.
But outside of these rules, you control when and how you withdraw funds. If there is a year that you expect your income to be lower, you may want to make larger taxable distributions from your accounts during that time, so your money can be taxed at a lower rate.
Choose tax-free investments
Retirees often transfer part of their retirement savings to bonds to maintain an adequate level of risk with age. Treasury bonds are generally exempt from tax at the state and local level, while municipal bonds are not taxed at the federal level. Explore these options to determine if they should be part of your portfolio.
Long term investments
Investment income may be taxed at the short-term capital gains rate or at the long-term capital gains rates (you should have held the investment for at least one year and one day). Long-term capital gains are taxed at a lower rate than short-term capital gains.
Social security income tax
Social security benefits are only taxed at the federal level when middle income exceeds a certain limit. Intermediate income represents half of the social insurance benefits, all taxable income, and part of non-taxable income, such as interest on municipal bonds.
You can ask your Social Security Administration to withhold taxes from your paycheck (just like employers), so you don't have to pay too much to the IRS when you file taxes. If you don't have a tax deduction, you may need to file estimated quarterly returns to pay tax for the entire year.
Taxes on IRA withdrawals and 401(k) accounts
Traditional IRA and 401(k) withdrawals are taxed at the normal rate of income tax. However, if you fail to take the required minimum distributions, you will be subject to a penalty of 50% of the unclaimed amount. Make sure to take your RMD to avoid additional penalties.
You can choose to withhold taxes on 401(k) or IRA distributions under certain circumstances (withholding is the standard option in some 401(k) plans). If taxes are not collected, you may need to pay estimated taxes on a quarterly basis to ensure that the IRS receives the amounts owed on a timely basis.
Capital Gains Tax
As a retiree, you can also have income from an investment in a taxable account. If so, it is important to understand the rules that apply:
Dividend income is generally taxed at preferential rates, provided certain criteria are met, including whether a US corporation or qualifying foreign corporation pays the dividend and is not included in the excluded categories. You must also have owned dividend-paying stocks for a specified minimum period. If your dividend is not considered "eligible," the normal tax rate will apply.
Income from the sale of an investment in excess of the amount paid is usually taxed at the long-term capital gains tax rate (if you have had it for at least a year and a day). If you sell it within a year, you will be charged at the short-term capital gains rate, which is the normal rate of income tax.
Interest income is generally taxed at the normal rate. This includes receipts for certificates of deposit (CDs), most interest on bonds, and interest on checking or savings accounts.
It is important to understand these tax rules when selecting investments so that you can accurately assess the amount of after-tax income they will provide in retirement.
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