An Easier Way To Estimate Your Retirement Tax Rate
Understanding how taxes are calculated on different sources of retirement income can be tedious and is not intuitive. Accurately estimating your retirement tax rate becomes more challenging if you are considering retirement locations in different states, which each have different tax structures. But it is worth a little bit of effort to familiarize yourself with these concepts.
However, once you understand the basics, it is much faster and easier to use a quality retirement calculator that computes federal and state taxes. Both the Pralana Gold and NewRetirement PlannerPlus calculators that affiliate with this blog do this. It is one of their most valuable features.
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Federal Taxes On Retirement Accounts
If you have a traditional 401 or traditional IRA, the IRS generally requires that you begin to take annual required minimum distributions during the year in which you turn 72 years old. Withdrawals from those accounts are generally taxed as ordinary income. The larger your savings in the account, the larger the withdrawal requirements, which could push you into a higher tax bracket than expected.
Youre Taxed In Retirement Based On What You Spend Not On What You Earn
Technically, your only income comes in the form of withdrawals from your own retirement and brokerage accounts. Theoretically, you wont be withdrawing more than you need to spend .
Of course, if you work for a really long time and make a lot of money, its possible your social security payouts will be decent but thats hard to project from our vantage points now, 40 years away.
Some of these accounts steed) are taxed like income, while others are taxed in a more favorable capital gains tax bracket .
Its likely youll pay 0% tax on your long term capital gains on some or all of your withdrawals from your taxable account, thanks to the way the brackets are set up.
But before we digress too far from the original point: Youll only be taxed more in retirement if youre spending more than youre earning now.
If youre like, Oh, I only make $80,000 now, but I plan to live an LLL in retirement: A Large, Lavish Life, baby! Lets pump the brakes, L^3.
This is the perfect segue to addressing the second piece of pushback: that youre going to be able to afford a crazy luxurious life in retirement that thrusts you into a higher tax bracket.
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Option : Roll Over Your 401 Into An Ira
Instead of keeping your funds in a 401, you may also choose to roll over your plan into an IRA. Youll do this with a bank or brokerage firm separate from your employer. This is a common choice for people who are leaving the workforce or for those who dont have an employer that offers a 401 plan.
The main benefit of an IRA versus a 401 is more flexibility in withdrawing money penalty-free before reaching the age of 59 ½. You also have direct access and more control over your investment options. You may have other investments and can now move this money to the same brokerage so that everything is in one plan, which consolidates logins.
If you choose to withdraw money from a rollover IRA, it may be used for a qualifying first-time home purchase or higher education expenses in addition to the exceptions for 401s.
The drawbacks of an IRA is that youll lose some hardship distribution options as well as qualified status, which means less protection of your assets. For example, if you were to be sued, some states would allow money in IRAs to be collected but not if it was in a 401.
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Why You Probably Wont Be In A Higher Tax Bracket In Retirement
It all comes down to this very simple truth:
In order to have enough money in retirement to live large, you have to invest a shit ton of money.
Why? Because the only way to grow a humongous nest egg is to fill it with a shit ton of cash, and preferably early in life so it has time to compound parabolically .
And in order to invest a shit ton of money, you have to make a shit ton of money .
And whats true about people who make a shit ton of money?
Theyre in a high tax bracket.
The paradox is this: If youre in a lower tax bracket now, the only way for you to be in a higher tax bracket in retirement is by spending a ton of money after you retire but you wont have a ton of money to spend unless youre earning a lot now. And if youre earning a lot now, youre likely already in a tax bracket that youll have a hard time eclipsing with spending later.
Does your head hurt? Cool. Lets add some numbers thatll help!
Traditional Ira And 401 Accounts
Traditional IRA and traditional 401 accounts are funded with pre-tax dollars. That is, you can deduct your contribution to a traditional IRA every year. That reduces your taxable income for the year while funding your retirement.
There are restrictions on how much money you can add to these accounts. For example, you may only invest up to $6,000 if you are younger than age 50 in a traditional account for the 2021 and 2022 tax years. If you are age 50 or older, you may contribute an additional $1,000 in catch-up funds for a total of $7,000.
The contribution for a 401 for 2021 is $19,500 and $20,500 in 2022, plus the additional catch-up contribution of $5,500 for both years.
You don’t even have to claim the deduction if it’s an employer-sponsored traditional 401. Your 401 contributions generally come directly from your paycheck, using pre-tax dollars. This lowers your taxable income for the yearand saves you money at tax time. With either type of accounta traditional IRA or 401your contributions and earnings grow on a tax-deferred basis until you eventually withdraw the money in retirement.
How To Pay Income Tax Or Other Additional Tax
There are several ways to pay your income tax or other additional tax:
- Tax withheld at source Generally, taxes are withheld from your pension income, but you may have to pay additional tax when you file your tax return. You can request additional taxes be withheld at source to lower the tax you owe when filing your tax return. For more information, see Do you end up having to pay income tax when you file your tax return every year?
- Paying your income tax by instalments If you receive investment, rental, or self-employment income, or certain pension payments, you may need to pay your income tax by instalments. For more information, see Required tax instalments for individuals
- Social benefits repayment You may have to repay all or a part of your old age security pension or net federal supplements when you file your tax return if your income exceeds a yearly threshold. If that is the case, a recovery tax will be deducted by Service Canada from your OAS benefits. You can request a waiver from the CRA to have Service Canada reduce your income tax withheld at source if you estimate that your income for the current year will be substantially lower than the previous year. For more information, see Line 23500 Social benefits repayment: Old age security benefits repayment
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How Is Social Security Taxed In Retirement
There’s a good chance that you won’t owe taxes on Social Security if it’s the only source of income you receive during retirement. That’s because your income will be too low to be taxable. But if you have other sources of income, including otherwise tax-exempt interest income, a portion of your Social Security benefits may incur a tax bill.
More than half of Social Security beneficiaries pay some tax on their benefits. The percentage of families receiving Social Security benefits who have to pay income taxes on them was less than 10% in 1984 and more than 50% by 2015. This figure may rise to 56% between 2015 and 2050, according to the Social Security Administration .
The amount of your taxable Social Security benefits depends on your combined income or the sum of:
Common sources of gross income include wages, salaries, tips, interest, dividends, IRA/401 distributions, pensions, and annuities.Common adjustments to gross income include health savings account contributions, deductions for IRA contributions, student loan interest deductions, and contributions to self-employed retirement plans.
|Up to 85% of SS may be taxable|
How Can I Receive A Direct Rollover
You can open an individual retirement account to receive a direct rollover. You must contact the individual retirement account sponsor to find out how to have your payment made to your account. If you are unsure of how to invest your money, you may want to temporarily establish an account to receive the payment. However, you may want to consider whether or not you may move any or all of the monies to another account at a later date without penalties or limitations.
If you choose to have the payment made to you and it is over $200, it is subject to the 20 percent federal income tax withholding. The payment is taxed in the year in which it is received unless within 60 days after receiving it you roll it over to an individual retirement account or retirement plan that accepts rollovers.
You can roll over up to 100 percent of the eligible distribution, including the 20 percent withholding. To do so, you must replace the 20 percent withholding within the 60 day period. You will be taxed on any amount that you do not roll over. For example, if you roll over only the 80 percent of the distribution, you will be taxed on the remaining 20 percent.
You can find more information about the taxation of payments from qualified retirement plans from the following IRS publications:
We won’t withhold any amount for federal income tax if your total taxable lump sum is less than $200. We will request a rollover election when you are eligible for a payment of $200 or more.
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An Example With An Average > High Earner For 25 Years
Lets assume this person is an average earner for the first 5 years of their career and then takes a rocketship to the 24%+ marginal tax bracket.
In this instance, where someone doubles their income in year 5 but sustains their same lifestyle indefinitely, they skid into year 25 with $4.5M giving them a safe withdrawal rate of $180,000 . Thats equivalent to about $75,000 of purchasing power in 2021 dollars, which means that if they were to withdraw $180,000 in their first year of retirement, theyd theoretically be in a higher tax bracket than they were in their first 5 years of working.
If you believe that your early salary is going to double or triple relatively early in your career but you plan to continue to live a similar lifestyle, the math would indicate theres a good chance youll be in a higher tax bracket in retirement.
But if you inflate your lifestyle? Say, you start spending $6,000/mo. instead of $3,333 when you get your big fat raise? Lets see:
Now, you hit year 25 with $3.2M, not $4.5M and you need $126,252 to support your lifestyle. Lucky for you, the safe withdrawal rate on $3.2M is $128,000, which means youve got just enough to cover your expenses. But remember $128,000 in 25 years from now is the equivalent of about $70,000 today, and by year 5, they were already in that $70,000 bracket.
Taxes On Pension Income
You have to pay income tax on your pension and on withdrawals from any tax-deferred investmentssuch as traditional IRAs, 401s, 403s and similar retirement plans, and tax-deferred annuitiesin the year you take the money. The taxes that are due reduce the amount you have left to spend.
You will owe federal income tax at your regular rate as you receive the money from pension annuities and periodic pension payments. But if you take a direct lump-sum payout from your pension instead, you must pay the total tax due when you file your return for the year you receive the money. In either case, your employer will withhold taxes as the payments are made, so at least some of what’s due will have been prepaid. If you transfer a lump sum directly to an IRA, taxes will be deferred until you start withdrawing funds.
Smart Tip: Taxes on Pension Income Vary by StateIts a good idea to check the different state tax rules on pension income. Some states do not tax pension payments while others doand that can influence people to consider moving when they retire. States cant tax pension money you earned within their borders if youve moved your legal residence to another state. For instance, if you worked in Minnesota, but now live in Florida, which has no state income tax, you dont owe any Minnesota income tax on the pension you receive from your former employer.
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Taxes On Investment Income
As a retiree, you may also have income coming in from investments in a taxable account. If that’s the case, it’s important to understand the rules that apply:
- Interest income is usually taxed at your ordinary tax rate. That includes income from certificates of deposit , most bond interest, and interest from checking or savings accounts.
- Income from selling an investment for more than you paid for it is usually taxed at either the long-term capital gains tax rate . If you sell it within a year, you’ll be taxed at the short-term capital gains rate, which is your ordinary income tax rate.
- Dividend income is typically taxed at preferential rates provided certain criteria are met, including being paid the dividend by a U.S. corporation or qualified foreign corporation and not falling into excluded categories. You also must have held the stock that pays the dividend for a certain minimum period. If your dividend isn’t considered “qualified,” it’s taxed at your ordinary income tax rate.
Understanding these tax rules is important when you select investments so you can make an accurate assessment of the amount of after-tax income they will provide during your retirement.
Calculating Your Tax Rate
Your tax rate in retirement will depend on the total amount of your taxable income and your deductions. List each type of income and how much will be taxable to estimate your tax rate. Add that up, then reduce that number by your expected deductions for the year.
For example, suppose that you’re married and filing a joint return with your spouse. You have $20,000 in Social Security income and $25,000 a year in pension income, and you expect to withdraw $15,000 from your IRA. You estimate that you’ll have $5,000 per year in long-term capital gains income from mutual fund distributions.
Your total income, not including capital gains and before Social Security benefits, is $40,000 . Your total income is $45,000 when you add in capital gains.
At $45,000, you’ll be taxed on up to 85% of your Social Security benefits. This doesn’t mean 85% exactly, because it’s a formula, so it may be less. Based on all of this information, you’ll pay taxes on $15,350 of your Social Security benefits. That means your income will be $60,350 .
You can type all of this information into a tax calculator to better understand how much you’ll pay in taxes.
Your standard deduction for 2021the tax return you file in 2022would be $25,100 as a married couple filing jointly. This increases to $25,900 in tax year 2022.
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Considering A Roth Account
Roth contributions may only make sense if you wont start taking withdrawals for at least five years, and if youll be at least 59-1/2 when you do start. Otherwise, withdrawals may not qualify as tax-free.*
If both these requirements will be met, consider the following questions. If your answer is yes to either of them, making Roth contributions could be right for you.
How To Reduce The Tax You Owe
You may be able to reduce your tax payable by taking advantage of a number of deductions or tax credits that may be available to you:
- Pension income splitting You and your spouse or common-law partner can choose to split your eligible pension or superannuation income
- Line 22100 Carrying charges, interest expenses, and other expenses You can claim carrying charges and interest you paid to earn income from investments
- Registered retirement savings plan Deductible RRSP contributions can be used to reduce the tax you owe
- Excess registered pension plan contributions between 1976 and 1985 If you made current service contributions exceeding $3,500 in one or more years from 1976 to 1985 that you could not deduct, call the CRA at 1-800-959-8281 to help you calculate your deduction and claim these amounts
- Non-refundable tax credits, such as the age amount, the pension income amount, and the amounts transferred from your spouse or common-law partner reduce the amount of income tax you owe. For more information, see Non-refundable and refundable tax credits
- Provincial and territorial deductions and tax credits You may be able to claim deductions and tax credits that are specific to your province or territory. For more information, see Provincial and territorial tax and credits for individuals
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