Five Things to Know About Taxes in Retirement

Courtney Jones, CFP®
Posted on 
October 28, 2021

Five Things to Know About Taxes in Retirement

Tax laws change frequently, and different types of income are subject to different tax treatments. Strategic, proactive tax planning can save thousands of dollars throughout an investor’s retirement, and in this article, we cover five things you need to know about taxes as you transition into living on different sources of income from when you were working.

Tax Rates Aren’t Always Lower

Many retirees assume that expenses, such as spending and taxes, will go down once they leave the workforce. However, this isn’t always the case. Even though earned income will be lower, several other factors affect how much tax will be owed.

First, retirees don’t always have the same tax deductions as employed individuals do, such as the benefits of contributing to a 401(k) plan. Retirees who are enrolled in Medicare also lose the ability to contribute to the triple tax-advantaged Health Savings Account. For those who took advantage of these deductions over the years, it can be challenging to find other deductions to replace their impact.

A lot of income in retirement comes from investment withdrawals, and that income is typically subject to capital gains taxes. Depending on your spending and other forms of income, you could end up with a similar tax rate to when you were employed.

Additionally, even though having a paid-off home is an accomplishment for many retirees, it also means losing the ability to deduct the mortgage interest from your taxable income. Lastly, given that tax rates are hovering near historical lows and government spending is poised to increase, tax increases are also likely. This put more emphasis on the need for proactive and strategic tax planning.

Required Minimum Distributions (RMDs)

An essential part of every retirement plan is addressing required minimum distributions. RMDs start at age 72 and play a role when taking withdrawals from retirement accounts such as 401(k)s and Traditional IRAs. Currently, the percentage required to withdraw in the first year is 3.65% and this percentage increases each year throughout retirement.

For those who have several different IRAs and 401(k)s, RMDs are treated a little bit differently than those who have one retirement account. With multiple IRAs, the RMDs are calculated for each IRA, but can be withdrawn from any account. RMDs are also calculated separately for multiple 401(k) accounts but must be withdrawn separately from each account.

Unlike the other investment accounts mentioned, Roth IRAs have the unique advantage of not requiring minimum distributions. This can play a beneficial role in income planning as they also provide tax-free income upon reaching age 59 1/2 (if the account has been opened for 5 years or longer). It’s also possible to convert an existing 401(k) or IRA to a Roth IRA through a Roth conversion. Taxes would be owed on the converted amount, but afterward, those funds would grow tax-free and could be withdrawn tax-free upon meeting requirements and would not be subject to RMDs.

Taxes on Social Security and the Medicare Surtax

Different types of income in retirement are treated differently from a tax perspective. Given that most retirees receive income from Social Security, it’s important to know how it’s taxed and what you can do about it.

In 2021, 15% of social security benefits received remain tax-free no matter what income level you’re at. However, this means that depending on your provisional income, up to 85% of Social Security income could be subject to federal income tax. Calculating your provisional income is done by taking the sum of 50% of your social security benefits, gross income, and any tax-free interest received.

In addition to the taxation of social security, higher income retirees may also be subject to an additional tax on investment income: the Medicare surtax. This is a surcharge on your Medicare Part B premium that applies over certain income levels. This income would include taxable interest and realized capital gains.

Having the flexibility to incorporate tax-free sources of income can make a tremendous difference in keeping your income below the level that would trigger the surcharge. Incorporating tax-advantaged strategies such as tax-loss harvesting can also help investors who are nearing those thresholds realize investment losses, ideally dropping them below the income surcharge levels.

Taxes on Estates

In 2021, an estate avoids federal estate taxes if the value is less than $11.7 million for single filers or $23.4 million for those married filing jointly. However, this high limit is only temporary. As of now, the threshold is scheduled to drop down to $5 million in 2026.

Aside from federal taxes, the estate may still owe taxes in their respective state, which can be different than the federal rate. An estate tax is assessed by the state in which the decedent was living at the time of death. The exemptions for state and district estate taxes are lower than those of the federal assessment. Some go as low, relatively speaking, as $1,000,000.  Also, the potential elimination of the stepped-up basis, could create a situation where all capital gains on assets within the estate are taxed based on the initial purchase price.

Given the likelihood of some changes to estate plans in the future, it may a be a smart idea to think through gifting strategies, like charitable trusts, whether to family or charitable institutions. Exploring the use of a trust can also be beneficial, as trusts are extremely flexible and have the added benefit of avoiding probate.

The Standard Deduction Increases

In recent years, the standard deduction was subject to an increase and became an attractive option for those who may have typically itemized their deductions. For retirees, the standard deduction becomes even more attractive. In 2021, the standard deduction for those who are married, and file jointly is $25,100. If both spouses are over the age of 65, that amount increases by $2,700.

Deciding on whether to take the standard deduction simply comes down to running the numbers and determining if itemizing would provide a larger deduction than the standard route.

The Takeaway

Taxes in retirement play a big role in your overall expenses and must be managed carefully to avoid overpaying. By knowing how different types of income are taxed and what your available options are, you can begin developing a strategy that helps you keep the most money in your pocket. You may consider different tactical moves and strategies before retirement, and you can consult a Certified Financial Planner to help you build a tax-efficient retirement income strategy.

Five Things to Know About Taxes in Retirement

Courtney Jones, CFP®
Posted on 
October 28, 2021
Five Things to Know About Taxes in Retirement

Five Things to Know About Taxes in Retirement

Tax laws change frequently, and different types of income are subject to different tax treatments. Strategic, proactive tax planning can save thousands of dollars throughout an investor’s retirement, and in this article, we cover five things you need to know about taxes as you transition into living on different sources of income from when you were working.

Tax Rates Aren’t Always Lower

Many retirees assume that expenses, such as spending and taxes, will go down once they leave the workforce. However, this isn’t always the case. Even though earned income will be lower, several other factors affect how much tax will be owed.

First, retirees don’t always have the same tax deductions as employed individuals do, such as the benefits of contributing to a 401(k) plan. Retirees who are enrolled in Medicare also lose the ability to contribute to the triple tax-advantaged Health Savings Account. For those who took advantage of these deductions over the years, it can be challenging to find other deductions to replace their impact.

A lot of income in retirement comes from investment withdrawals, and that income is typically subject to capital gains taxes. Depending on your spending and other forms of income, you could end up with a similar tax rate to when you were employed.

Additionally, even though having a paid-off home is an accomplishment for many retirees, it also means losing the ability to deduct the mortgage interest from your taxable income. Lastly, given that tax rates are hovering near historical lows and government spending is poised to increase, tax increases are also likely. This put more emphasis on the need for proactive and strategic tax planning.

Required Minimum Distributions (RMDs)

An essential part of every retirement plan is addressing required minimum distributions. RMDs start at age 72 and play a role when taking withdrawals from retirement accounts such as 401(k)s and Traditional IRAs. Currently, the percentage required to withdraw in the first year is 3.65% and this percentage increases each year throughout retirement.

For those who have several different IRAs and 401(k)s, RMDs are treated a little bit differently than those who have one retirement account. With multiple IRAs, the RMDs are calculated for each IRA, but can be withdrawn from any account. RMDs are also calculated separately for multiple 401(k) accounts but must be withdrawn separately from each account.

Unlike the other investment accounts mentioned, Roth IRAs have the unique advantage of not requiring minimum distributions. This can play a beneficial role in income planning as they also provide tax-free income upon reaching age 59 1/2 (if the account has been opened for 5 years or longer). It’s also possible to convert an existing 401(k) or IRA to a Roth IRA through a Roth conversion. Taxes would be owed on the converted amount, but afterward, those funds would grow tax-free and could be withdrawn tax-free upon meeting requirements and would not be subject to RMDs.

Taxes on Social Security and the Medicare Surtax

Different types of income in retirement are treated differently from a tax perspective. Given that most retirees receive income from Social Security, it’s important to know how it’s taxed and what you can do about it.

In 2021, 15% of social security benefits received remain tax-free no matter what income level you’re at. However, this means that depending on your provisional income, up to 85% of Social Security income could be subject to federal income tax. Calculating your provisional income is done by taking the sum of 50% of your social security benefits, gross income, and any tax-free interest received.

In addition to the taxation of social security, higher income retirees may also be subject to an additional tax on investment income: the Medicare surtax. This is a surcharge on your Medicare Part B premium that applies over certain income levels. This income would include taxable interest and realized capital gains.

Having the flexibility to incorporate tax-free sources of income can make a tremendous difference in keeping your income below the level that would trigger the surcharge. Incorporating tax-advantaged strategies such as tax-loss harvesting can also help investors who are nearing those thresholds realize investment losses, ideally dropping them below the income surcharge levels.

Taxes on Estates

In 2021, an estate avoids federal estate taxes if the value is less than $11.7 million for single filers or $23.4 million for those married filing jointly. However, this high limit is only temporary. As of now, the threshold is scheduled to drop down to $5 million in 2026.

Aside from federal taxes, the estate may still owe taxes in their respective state, which can be different than the federal rate. An estate tax is assessed by the state in which the decedent was living at the time of death. The exemptions for state and district estate taxes are lower than those of the federal assessment. Some go as low, relatively speaking, as $1,000,000.  Also, the potential elimination of the stepped-up basis, could create a situation where all capital gains on assets within the estate are taxed based on the initial purchase price.

Given the likelihood of some changes to estate plans in the future, it may a be a smart idea to think through gifting strategies, like charitable trusts, whether to family or charitable institutions. Exploring the use of a trust can also be beneficial, as trusts are extremely flexible and have the added benefit of avoiding probate.

The Standard Deduction Increases

In recent years, the standard deduction was subject to an increase and became an attractive option for those who may have typically itemized their deductions. For retirees, the standard deduction becomes even more attractive. In 2021, the standard deduction for those who are married, and file jointly is $25,100. If both spouses are over the age of 65, that amount increases by $2,700.

Deciding on whether to take the standard deduction simply comes down to running the numbers and determining if itemizing would provide a larger deduction than the standard route.

The Takeaway

Taxes in retirement play a big role in your overall expenses and must be managed carefully to avoid overpaying. By knowing how different types of income are taxed and what your available options are, you can begin developing a strategy that helps you keep the most money in your pocket. You may consider different tactical moves and strategies before retirement, and you can consult a Certified Financial Planner to help you build a tax-efficient retirement income strategy.

Registered Representative of Sanctuary Securities Inc. and Investment Advisor Representative of Sanctuary Advisors, LLC. Securities offered through Sanctuary Securities, Inc., Member FINRA, SIPC.  Advisory services offered through Sanctuary Advisors, LLC., an SEC Registered Investment Advisor. Credo Wealth Management is a DBA of Sanctuary Securities, Inc. and Sanctuary Advisors, LLC. This work is powered by Seven Group under the Terms of Service and may be a derivative of the original. More information can be found here. This communication has not been reviewed for completeness or accuracy, does not necessarily reflect the views of Sanctuary Securities, Inc. or Sanctuary Advisors, LLC., and is not a recommendation or endorsement of any product, service, or issuer. For additional information, please refer to one of the following consumer websites: www.FINRA.org, www.SIPC.org.

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