Over the years, my firm’s financial advisors have helped more than 1,000 people retire.
A common concern for pre-retirees is paying taxes on their retirement income. To understand how taxes work in retirement, it is first important to understand how different sources of retirement income will be taxed. For this article, I will narrow down a few common sources of retirement income. I will focus primarily on federal income taxes as each state has unique rules that are too extensive to cover in this article.
Top Retirement Income Sources And Their Tax Implications Explained
Social Security
Taxation of Social Security is dependent on an individual or a couple’s total income. Lower income earners may not have any tax on their Social Security, while others may be taxed on up to 85% of their Social Security income. The portion of one’s taxable Social Security will be taxed at the person’s ordinary income tax rate.
For example, if someone has $20,000 in Social Security income, 85% of it may be taxed. If this person is in the 22% tax bracket, their tax burden would be $20,000 times 85%, which equals $17,000. The $17,000 taxed at 22% would equal $3,740 in taxes.
Pensions
Most pensions are fully subject to taxation at the federal level.
IRA, 401(k), 403(b) And Other Pre-Tax Retirement Plans
Distributions from these types of investments are generally subject to income tax in the year the distributions are taken.
Roth IRA, Roth 401(k), Roth 403(b) And Other Post-Tax Retirement Plans
Qualified distributions from these types of investments are generally income tax-free.
Non-Retirement Investment Accounts (Non-Qualified Accounts)
Distributions from bank accounts, brokerage accounts and other non-qualified investments that are not held in retirement accounts can vary greatly depending on the type of investment owned. Any money invested into non-qualified accounts can generally be withdrawn tax-free because the amount invested has already been previously taxed. Any interest, gains, growth and dividends may be subject to tax depending on a variety of factors.
Two Common Ways To Pay Taxes In Retirement
1. Withholding Method
One popular method for paying taxes in retirement includes having taxes withheld from your various sources of income. Many individuals can cover their entire tax burden utilizing the withholding method. To avoid penalties using this method, you must follow specific guidelines, as outlined on the IRS website. In general, taxpayers don’t have to pay a penalty if they meet either of these conditions:
• They owe less than $1,000.
• Throughout the year, they paid at least the smaller of these two amounts:
1. At least 90% of the tax owed for the current year.
2. 100% of the tax shown on their tax return for the prior year (this can increase to 110% for higher-income earners).
The key to using the withholding strategy effectively requires estimating the collective total annual income tax amount you will have to pay. Once you have estimated the total amount you owe, you need to withhold enough from your various sources of income to ensure you are avoiding the penalties previously mentioned. It does not matter how much you withhold from any one source of income if the total withholdings are sufficient to avoid penalties.
Social Security will allow you to withhold either 7%, 10%, 12% or 22% from your monthly payments. Similarly, most employers who provide a monthly pension for retired employees also allow individuals to withhold a percentage of their monthly pension income.
Finally, most investors who collect income from pre-tax investments can choose to withhold taxes. For example, if you collect income from an IRA, most IRA custodians will allow you to withhold a percentage of each payment you receive. Many individuals can fulfill their entire tax obligations through the withholding amounts they choose from Social Security, pensions and pre-tax retirement account distributions.
The primary benefit for individuals who can fulfill their entire tax obligation through the withholding method is simplicity. Unfortunately, many people who have more significant net worths and income sources will not be able to fulfill their tax obligations through withholding alone. These individuals will have to satisfy all or a portion of their tax bill by paying quarterly estimates.
2. Quarterly Estimate Method
The IRS considers federal taxes a pay-as-you-go system. In other words, they want taxes paid when the income is earned. For this reason, you generally cannot pay your entire tax bill at the end of the year.
To avoid late payment penalties, many investors will choose to use the quarterly estimate method. This method requires individuals to pay income taxes four times per year prior to specified dates set by the IRS. Failure to pay estimated income taxes prior to each quarter’s deadline can result in penalties. To avoid penalties, you need to make payments before the due dates. You must also follow the same rules as before with the withholding method.
You must make quarterly payments if you owe over $1,000 after considering withheld amounts and tax credits received. You will have to pay in the lesser of the following two amounts: at least 90% of the tax owed for the current year or 100% of the tax shown on their tax return for the prior year—this increases to 110% for higher income earners.
In summary, some retirees can fulfill their entire tax obligation by estimating their tax burden and withholding the appropriate amounts from their various sources of retirement income. Other individuals will need to pay quarterly estimates to satisfy their tax obligations.
If determining the appropriate amount to pay for taxes seems overwhelming, consult your tax professional or contact a financial advisor who offers tax planning services.
Originally published in Forbes on October 2, 2024.
Source: IRS website Topic no. 306, Penalty for underpayment of estimated tax
The use of Ty Bernicke’s research or publication of articles he has written does not indicate an endorsement of his work as an Investment Advisor. The publications did not receive compensation for publishing Mr. Bernicke’s work.
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