February 19, 2021

Edited 02/19/21

How to Prepare for the Taxes You’ll Pay in Retirement

When you’re compiling your retirement nest egg, don’t forget to plan for the taxes you’ll have to pay on some of those funds.

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If you’re like most people looking ahead to retirement, you’ve thought about the money you’re going to bring in during those years. Maybe you’re always checking in on your 401(k), or you’ve calculated how much your Social Security check will be if you can hold off on taking it until your 70th birthday. 

But have you thought about the money that will be going out during retirement, specifically the funds you’re going to have to fork over to the IRS? Some people forget that ending your employment doesn’t always mean an end to your tax-paying days. 

Thankfully, though, there are ways to plan for the post-retirement taxes you’ll pay and optimize your income to avoid handing it all over. Not sure where to start? Check out our guide:

Retirement Taxes: Social Security

Back in the 1980s, fewer than 10% of households were taxed on their Social Security incomes. Today, that number has risen to more than half. But how much you’ll be taxed depends on a few different factors:

  • If Social Security is your only income: It’s likely you won’t be taxed on your Social Security, since your income will be below the taxable threshold. The exception is if you are single and your Social Security income totals more than $25,000 per year. Then, you could be taxed on part of those benefits. 
  • If you’re filing single and your total income is $25,000 – $34,000: This singleton filing includes qualifying widows or widowers, as well as those married and filing separately. If this is your bracket, 50% of your Social Security benefits may be taxed. 
  • If you’re married and filing jointly, and your combined income is $32,000 – $44,000: 50% of your benefits are taxable.
  • If you’re filing single and your total income exceeds $34,000: This singleton filing includes qualifying widows or widowers, as well as those married and filing separately. If this is your bracket, up to 85% of your benefits are taxable. 
  • If you’re married and filing jointly, and your combined income exceeds $44,000: Up to 85% of your benefits are taxable.

Keep in mind that these percentages represent what it’s possible to collect on federal taxes. If you live in one of the following 13 states, you may also be subject to some degree of state taxes on your Social Security income, though each of these has different policies: Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, and West Virginia. 

And remember that you don’t have to start taking your Social Security right when you turn 62. In fact, each year that you delay helps your eventual benefit check grow by 8% (until you’re 70). In order to efficiently plan for your Social Security income, use our calculator to figure out what your benefits would look like depending on when you take it.

Retirement Taxes: Distributions & Withdrawals

If you’ve been saving for retirement in a tax-deferred account like a 401(k) or a traditional IRA, don’t forget that you’ll eventually have to start paying taxes on that money once you start withdrawing from it. 

Pensions typically follow the same rules—they were contributed to with pre-tax dollars, so once you start getting them, that income will be taxable. 

Generally, you’ll be taxed at your ordinary income tax rate on the income from 401(k)s, traditional IRAs, and pensions.

Some people don’t need the immediate income time or delay their withdrawals to minimize the amount of taxable income they’ll have in a year. That’s okay—to a point. Remember that once you hit a certain age (anywhere from 70 ½ to 72, depending on when you were born), you’ll have to start taking a required minimum distribution (RMD). If you don’t take yours, you’ll receive a tax penalty of up to 50% on the amount that should have been withdrawn.

On the other hand, if you’ve been saving for retirement via a Roth IRA, your withdrawals will be tax-free, with a few caveats. You’ll likely face a penalty of up to 10% on the amount withdrawn if you try to withdraw before you hit 59 ½, and you must have had your Roth IRA for at least five years before you start withdrawing from it.

If you’ve inherited an IRA, you also have to be careful about the RMDs from that account, since rules have changed recently thanks to the SECURE Act. You’ll likely be able to delay taking an RMD on an inherited IRA until you’re 72 (as opposed to the previous 70.5), giving that money a little more time to grow if you can afford to hold off on the withdrawal.

Retirement Taxes: Investments

When it comes to tax rules, investment income from streams like dividends, rental income, bonds, or mutual funds can start getting complex, but there are a few general guidelines.

  • Capital gains: Capital gains can be incredibly tax-friendly. As long as you’ve held on to an asset like real estate or gold for more than one year before you sold it at a profit, you’ll likely pay taxes on that profit at a lower rate than you would ordinary income. For instance, if your income as a single filer is below $40,000 and married filing jointly is below $80,000, your tax rate on the gains will be 0%. If it’s anywhere from $40,000 (or $80,000 for married) to $441,450 (or $496,600), you’ll pay a 15% rate. 
  • Investments outside retirement plans: There are specific rules for different types of investments, but in general, you’ll be taxed on dividends or investments like rental income at your ordinary income tax rate. An exception would be most types of municipal bonds, which are typically free from federal and sometimes state taxes.
  • Savings bonds: There are a few different ways savings bonds can be taxed, depending on their type. If you’ve got an HH bond, you’ll report it every year that you have it and pay federal tax on its interest at your ordinary income rate each year. You should be able to avoid tax on the interest of EE and I bonds, if they’re used to cover for higher education costs (excluding room and board) for either the bondholder, their spouse, or their dependent. They also would have had to be purchased after 1989 by someone 24 or older, and in the taxpayer’s name.

Retirement Taxes: Location

One of the biggest factors in how much you’ll pay in taxes, whether you’ve already retired or not, is your location. Property, income, and state taxes can vary wildly between states, and some states offer breaks once you reach a certain age. 

For a breakdown of what those differences look like across the US, check out our complete guide to the most retiree-friendly states.

Tips on Planning for Retirement Taxes

Though every retirement income is different, there are still a few ways you may be able to plan to diversify your taxes as you plan for retirement:

  • Look into an HSA. Even if your employer doesn’t offer a health savings account, you can get one through services like Lively. There’s a few tax benefits here. First, your contributions aren’t subject to federal income taxes. Then, once you start withdrawing for qualifying medical expenses, those withdrawals won’t be taxed. As a bonus, even the interest that you grow in this account will be tax-free, as long as it’s used for qualifying expenses.
  • Time your withdrawals. Your taxable income can fluctuate during retirement and the years preceding it, especially if you have a wide variety of investments or income streams. For instance, maybe you’re planning a retirement move, and want to use capital gains to finance that. Or, maybe you know that one year you plan on collecting a consulting fee for a six-month project, but won’t be working the next year. Try to gauge your income each year so you can time your withdrawals to avoid being pushed into a higher-tax bracket. Maybe you decide to defer a 401(k) withdrawal in one of the years your income is a little padded (as long as you’re in an age group that can do that), while you might take more than the RMD in a different year when you know you’ll have several available deductions.
  • Look into a Roth conversion: If your taxable retirement income is adding up quicker than you thought it would, you might consider moving some of your assets from a tax-deductible fund like a traditional IRA to a Roth IRA. You will have to pay taxes on that initial conversion. But once the money is held in your Roth, you won’t pay federal income taxes on your withdrawals moving forward. Some people convert during a time when their taxable income is lower, planning ahead to be able to spread out that tax-free income to years when they’re predicting higher taxable incomes.
  • Consider giving assets or transferring wealth. Depending on what you plan on bequeathing after your death, you may want to look into ways to make sure those assets are subject to minimal estate or inheritance taxes. Keep in mind that if you’re planning on having one of your beneficiaries inherit an IRA and have benefitted from delaying an RMD thanks to the SECURE Act, the beneficiary may face a significant bump of taxable income in the year they inherit, especially if they’re in their peak earning years. To avoid some of those taxes, you might choose to transfer wealth to your beneficiaries, or make sizeable charitable donations, while you’re still alive. Depending on the size of these gifts and where they go, you may be able to do this completely tax-free—just make sure you’re prepared to live without that money going forward.

No audits or headaches here!

Even with all this information, filing your taxes can be frustrating and confusing. That’s why most people turn to tax software to walk them through it. With options like live support from tax experts and prompting questions to help you discover deductions you didn’t know existed, you’ll find that doing your taxes doesn’t have to be the headache you thought it was.

Not sure which tax software program meets your specific needs? We’ve put together a complete guide of our favorites for every tax situation you might have.

And don’t forget to get your full retirement score using Silvur. You’ll be able to see the full scope of where you stand now, figure out what your score would look like if your employment, living, or budget situation changed, and spot the areas of your budget you could trim in order to boost your score. Knowing where you stand can help you prepare and look forward to living your best life in your retirement years.