Hidden Taxes in Retirement

At the risk of sounding like a fearmonger, I’d like to share with you the fact that your taxes in retirement may be a lot more complicated than while you’re working.

But the rewards are tremendous if you are willing to start early, dedicate the time to planning, and ask for assistance. One of the basic concepts in retirement is to be as tax-efficient with your income as possible.

Many retirees can control their taxable income each year by the amount they work and how much they withdraw from retirement savings accounts like IRAs and 401(k)s. When your withdrawals drive you into a higher income tax bracket, you will need to decide if you want to minimize the tax rate applied to this range of income.

In 2020, income tax rates range from 0 to 37 percent, plus a potential 3.8 percent net investment tax for higher-income individuals. Understanding how these progressive tax rates apply to ordinary income creates a tremendous retirement planning opportunity.

Case Study:

You are a single taxpayer with $10,000 in retirement income from a part-time job. You also have $150,000 savings in a 401(k) retirement account. The income range and applicable tax rate for a single taxpayer in 2020 is as follows:

In this example, excluding other variables, you have the opportunity to withdraw an additional $30,125 from the 401(k) at an income tax rate of 12 percent. $10,000 from your part-time job plus $30,125 from your 401(k) equals $40,125, which is close to the top of the 12 percent income tax bracket. Any additional income you receive above $40,125 will be taxed at 22 percent or higher.

*Note: Taxable income typically includes wages, interest, non-qualified dividends, short-term capital gains (assets owned for one year or less), taxable Social Security benefits and withdrawals from most 401(k), 403(b), and non-Roth IRAs.

1. Your Social Security benefits may be taxable.

Whether and how much of your Social Security benefit is taxed will be determined by “combined income.” That’s your adjusted gross income, plus any non-taxable interest, plus half your Social Security benefit. If your combined income is below $25,000 and you’re single, your benefit won’t be taxed. If your combined income is between $25,000 and $34,000, you may pay tax on up to half of your benefits. Over $34,000, up to 85 percent of your benefits may be taxable. For joint filers, the 50 percent range is $32,000 to $44,000, and the 85 percent range is over $44,000.

SOLUTION - As the tax calculations are fairly complex, I would suggest you use software, or a tax advisor, to figure yours.

2. Required minimum distributions may trigger higher taxes.

At age 70½, you must begin withdrawing money from most retirement accounts. Required minimum distributions typically are taxed at your regular income tax rates. If you’ve been a diligent saver, these mandatory distributions could be big enough to push you into a higher tax bracket.

SOLUTION - In some cases, it can make sense to convert some retirement funds to Roth IRAs in your 60s to avoid a sharp increase in taxes in your 70s. A tax pro or financial planner could help you run some projections to see if this approach makes sense.

3. State income tax could take another bite.

You’ll pay federal income taxes on most retirement plan withdrawals, but additional state taxes depend on where you live. Tax rates on investments can vary as well. In 13 states, you also could owe state income tax. Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont and West Virginia all tax Social Security benefits to some extent.

Seven states don’t tax income: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. New Hampshire and Tennessee tax only dividends and interest.

Elsewhere retirement income may be exempt, partly exempt, offset by a credit or fully taxable. Sales, property and use taxes vary hugely as well. Please note that use taxes are imposed by counties and municipalities to fund public services such as libraries or fire protection.

SOLUTION - Anyone thinking of moving to a new state in retirement should thoroughly research the state’s tax laws, or ask a tax pro for help.

4. Beware of state estate, inheritance, capital gain taxes etc.

Federal estate taxes aren’t an issue for most people, now that $11,180,000 per person is exempt. But 12 states and the District of Columbia also levy estate taxes. Hawaii, Maine and the District of Columbia use the federal exemption amount, but Oregon and Massachusetts may tax estates worth $1 million or more.

The other states — Connecticut, Illinois, Maryland, Minnesota, New York, Rhode Island, Vermont and Washington — exempt varying amounts. Meanwhile, Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania have inheritance taxes, which may tax people receiving bequests.

SOLUTION - Consult an estate planning attorney if you might be affected, since you may be able to minimize taxes with the right plan.

5. Home sales can cause unexpected tax bills.

If you do end up moving to another state and have been a homeowner, selling your home, also because of downsizing or freeing up equity, may generate a tax bill.

If you’ve lived in your primary residence for at least two of the five years prior to selling it, you can exempt up to $250,000 of home sale profit from capital gains taxes (or up to $500,000 for a couple). Profits above that are subject to federal capital gains tax rates that range from 0 percent to 20 percent.

You also may owe a “depreciation recapture tax” if you took a home office deduction, rented out rooms or rented out the whole house. The depreciation you took or should have taken over the years is added back to your income in the year you sell and you’ll pay a maximum rate of 25 percent on it.

SOLUTION - Two to three years before you contemplate moving, make sure you take into account how long you have been in the current residence, and depreciated taken if you have taken the depreciation on the property on your taxes before.