If you dread tax day every year, here’s some good news: Your tax burden will likely decrease when you retire.
You continue to pay taxes on income you receive from sources that have not yet been taxed, such as B. 401(k) and individual retirement accounts or a defined benefit pension. Depending on your income, your social security benefits may also be taxed. And higher-income seniors pay surcharges on Medicare premiums, which, while not technically taxes, certainly feel like it to retirees.
But for most households, tax rates fall in retirement, according to research from the Investment Company Institute and the Internal Revenue Service. “Part of the drop is because you don’t pay payroll taxes, but income taxes tend to go down, both because your total income is typically lower and because only a portion of Social Security is taxable,” Peter Brady, senior economic adviser at the institute, said Trade group representing the wealth management industry.
Careful planning can reduce your tax burden in retirement, experts say. “Efficient tax management can have a pretty big impact,” says Wade Pfau, retirement income expert and author of the Retirement Planning Guidebook. “Especially if you have a large IRA, some planning can really help.”
Here are the top ways income will be taxed in retirement and some strategies that can help you be as tax efficient as possible.
About half of Social Security recipients pay federal income taxes on a portion of their benefits. The tax affects retirees with relatively higher incomes, but the share of taxpayers is increasing.
Taxation of benefits is triggered when certain types of income exceed a threshold. The income formula used to determine it is called “combined income” (sometimes called “provisional income”). It’s the sum of your adjusted gross income, tax-free interest, and half of your Social Security benefits.
If your combined income is less than or equal to $25,000 (for single persons) or $32,000 (for married persons), no tax is due on your benefits.
Beneficiaries at the next income bracket — between $25,000 and $34,000 for single parents and between $32,000 and $44,000 for joint-filing couples — pay up to 50 percent of their benefits in federal income taxes. Beneficiaries with a higher income pay taxes on up to 85 percent of the benefits.
The benefits were first taxed in 1984 as part of a package of reforms passed the previous year aimed at stabilizing the program’s finances — the proceeds go to the Social Security and Medicare trust funds.
The tax thresholds aren’t indexed to inflation, so over the years more and more retirees have had to pay taxes — and many continue to express frustration about them, said Ed Slott, a tax expert who frequently conducts educational seminars for consumers and financial planners.
“I’m always asked why Social Security benefits are taxed,” he said. “It’s been like this for decades, but people still complain about it.”
Each January, the IRS will send you Form SSA-1099 showing the total amount of benefits you received from Social Security in the previous year to file your tax return. It is also possible to withhold taxes from your benefits by completing Form W-4V.
The US pension system is structured to provide tax advantages when saving.
Contributions by you and your employer to defined contribution plans are exempt from taxable wages and investment income earned on contributions is not taxed. These tax savings offer a powerful benefit that will help your portfolio grow over time.
But income taxes are due when you deduct those dollars.
“Think of your IRA as a joint account with Uncle Sam, because that’s what it is,” Mr Slott said. “Some of that money is owed back to the government when you withdraw it in retirement – how much depends on your future tax rates.”
Most workers approach retirement with the bulk of their savings in tax-deferred accounts. According to the Investment Company Institute, as of the third quarter of 2021, Americans had $37 trillion in retirement savings — and most of it in defined contribution plans, IRAs, or defined benefit pensions.
It may make sense to diversify your savings over the years that you save to include a Roth IRA or Roth 401(k). These accounts are funded with post-tax dollars. No tax is paid on withdrawals of deposited funds or investment gains as long as two important withdrawal rules are observed. First, you must be over 59½ years of age; Second, your Roth account must have been in existence for at least five years.
But from a tax standpoint, the value of saving on tax-deferred or Roth vehicles depends on your current and future tax rates. “If your income tax rate is the same at the time of deposit and withdrawal, that’s an equivalent result,” said Dr. brady
Higher-income retirees pay surcharges on their Medicare Part B (outpatient benefits) and Part D (prescription drugs) premiums. Formally known as earnings-related monthly adjustment amounts, they can significantly increase Medicare costs.
The Social Security Administration uses the most recent tax return they can access with the IRS to determine whether you need to pay a supplement, usually two years prior to the year for which the premium is assessed. This retrospective function allows the supplement for medium-sized employees to be triggered in the early years of retirement, as it takes your last salary years into account.
There are five bonus levels, defined by your modified adjusted gross income. Medicare members who fall into these categories bear a higher percentage of the total program cost. While Medicare sets the standard Part B premium at 25 percent of the total program cost each year, those subject to the surcharge pay 35 to 85 percent of that cost.
This year, that means a Part B surcharge of $68 per month for a retiree filing a single tax return with modified adjusted gross income between $91,000 and $114,000. Your total reward is $238.10 instead of $170.10. Part D supplement is less – this year $12.40 for seniors who fall in the first group.
From then on, the surcharge levels jump significantly. And they have nothing graduated, Mr. Slott remarks. “I call it a cliff – if you’re a dollar over, you pay the full amount.”
The current high rate of inflation will help some Medicare members avoid surcharges as bracket definitions are adjusted annually for inflation. “It looks like fewer people are paying the surcharges,” said Ron Mastrogiovanni, chief executive officer of HealthView Services, a Boston-area maker of healthcare cost forecasting software.
The two-year lag effect can create unpleasant surprises when you first enroll in Medicare. It is possible to challenge premium increases when your income has declined due to a number of defined ‘life-changing’ circumstances – and one of which is stopping work. Submit your appeal using the Social Security Administration Form SSA-44.
Many states exempt retirement income, although specifics vary widely. Eight states have no personal income taxes, but among those that do, about three-quarters exempt Social Security benefits entirely from taxation, and most others have partial exemptions for lower-income retirees, according to a study by the Institute on Taxation and Economic Policy. a nonpartisan nonprofit group. Many states also have partial or full exemptions for retirement income and additional personal exemptions or reductions.
“It’s very common for a portion of retirement income to be deferred at the state level,” said Aidan Davis, the group’s acting policy director. “And we’re seeing a big trend this year of more states cutting taxes on retirees,” she added.
Strategies for tax efficiency
Careful pre-retirement planning can help minimize or even avoid some of the knock-on effects that taxes on Social Security and Medicare surcharges can cause. The goal is to reduce taxable income wherever possible by diversifying your holdings outside of tax-advantaged accounts.
Saving for retirement in a Roth IRA or a Roth 401(k) offers a way to achieve this goal, as do Roth conversions, especially in the early years of retirement before you apply for Social Security.
For workers enrolled in high-deductible health insurance plans, a health savings account can be helpful. These accounts can be used to pay for out-of-pocket healthcare costs in retirement; Contributions are tax-deductible, and investment growth and interest are tax-free, as are payouts for qualifying medical expenses. Contributions to these accounts must generally end six months before your Medicare enrollment becomes effective.
It can also make sense to make charitable contributions from an IRA. If you are at least 70½ years old, you can give up to $100,000 annually to charities by using Qualified Charitable Distributions. There is no income tax on these distributions and they also count towards your annual required minimum distributions.
This is a particularly attractive strategy for retirees who don’t file deductions on their tax returns, said Dr. Peacock. This is often the case because seniors typically have fewer deductions and their standard deduction is slightly higher (for tax year 2021, an individual filing taxpayer aged 65 and older can add $1,700 to the standard deduction of $12,550).
“Because these payouts don’t count towards your adjusted gross income, they can help with things like Medicare surcharges and taxation of Social Security benefits,” he said.
https://www.nytimes.com/2022/03/25/business/retirement-taxes-social-security.html Pay taxes in retirement – The New York Times