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Estimating Taxes in Retirement

November 06, 2017
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Just because you’ve exited the workforce doesn’t mean you stop paying taxes. You don’t want to be surprised by the IRS in retirement. Just as you create a budget for living expenses in retirement, so too should you budget for tax withholdings or quarterly tax payments.


And because you will likely have multiple sources of income in retirement, you should learn how each one is taxed. Here, we are going to discuss how six of the most common types of retirement income are taxed: social security income, IRA and 401(k) withdrawals, pensions, annuity distributions, investment income, and gains from the sale of your home.


  1. Social Security income


Social Security is a major source of income for the vast majority of the elderly: ninety percent of people 65 and older receive Social Security benefits. Those benefits are yours, you paid for them – but you still have to pay taxes. The IRS published Notice 703 to help recipients determine what portion of their Social Security income is taxable, if any. Depending on your combined income from other sources, such as pensions and 401(k)s, anywhere from zero to eighty-five percent of your Social Security benefits are taxable.


  1. IRA and 401(k) withdrawals.


If you withdraw money from one of your retirement accounts, including your IRA, 401(k), 403(b), 457 plans, etc., you will most likely have to pay taxes as you would while you were still working. You’ll have to file these distributions on your income tax return. Your taxes will depend on your combined income, deductions, including medical expenses, and your tax bracket.


There are exceptions to retirement account taxation, based mostly on whether you made pre-tax or taxed contributions. Roth IRA withdrawals, for example, are tax-free because contributions are taxed.


  1. Pensions


While certain types of pensions are partially or fully tax-free, such as some military or disability pensions, most pensions will be taxed as ordinary income. Knowing how much of your pension is taxable is easy, because the pension provider will mail you a 1099 form at the start of each year. For convenience, you can request taxes be withheld directly from your pension check.


  1. Annuity distributions


The amount you pay in taxes on annuity distributions will depend on the type of annuity. For annuities owned by an IRA or other retirement account, distributions are subject to the same tax-rules as IRA withdrawals.


If you invested in an immediate annuity, your distributions are composed of a portion of the principal you initially invested and the interest earned on that investment. The interest portion is taxable while the principal is not. If you want to know exactly how much of your immediate annuity income will be taxed, you can ask for your “exclusion ratio”.


If you invested in a fixed or variable annuity, you must withdraw your earnings, or interest and investment gains, first. After all earnings are withdrawn, you’ll begin to receive distributions of your original contributions, which are not considered taxable income.


  1. Investment income


Dividends, interest income, and capital gains are taxable. The financial institution that manages your accounts will send you a 1099 form reporting each source of investment income. There are ways to reduce the amount of taxes you owe on certain types of investment income, specifically capital gains. For example, you may qualify for the zero percent capital gains tax rate or you can manage your capital gains and losses to mitigate tax payments.


  1. Gains from the sale of your home


Returns from the sale of your home are treated as capital gains – that is, money earned from the sale of an asset. If the home was your primary residence, meaning you lived there for more than two years, your earnings are considered a long-term capital gain and will likely be taxed at a rate between zero and twenty percent. However, you can exclude a certain portion of your gains: $250,000 if you’re single and $500,000 if married.  


This is just a quick overview of how certain types of retirement income are taxed. Since individual finances vary, IRS guidelines may change, and state tax laws differ (some states are more retirement friendly than others), you should seek the guidance of a certified retirement income planner to help you prepare for exiting the workforce. If you want to ensure you’re financially prepared for your Golden Years, please contact Ventura’s Retirement Income Specialists. We’ll take the guess work out of your retirement needs.


You can also fill out the quick form on this page for your free consultation.