Taxes and Retirement – Are You Prepared for the Consequences of Taxation?

Back in the day, it used to be that our predecessors followed the typical path of going to school, working until retirement, then living off their pensions in their golden years. But this former par-for-the-course scenario no longer seems as plausible as it had in the past. 

The rising cost of inflation and longer life expectancy, and reduced social security and insurance packages have shrunk the value of expected retirement benefits. In fact, hanging up one's hat seems a less enticing and more daunting prospect today. One thing's for sure: we need to take retirement planning more seriously. What are your potential future income sources, and how can they be impacted differently by retirement taxes?

How will my retirement affect my taxes?

Taxes on Social Security Benefits

The larger your income, the higher the portion of your Social Security benefits will be subject to taxes. You will only need to pay taxes on up to 50% of your SS income if you're filing your federal tax return as an individual and you have a combined income (or other income) in the range of $25,000 to $34,000. If your total income exceeds $34,000, you could pay taxes for as much as 85% of your Social Security benefits. If you're married, you typically file a joint tax return, and you and your spouse have additional or combined income that falls within $32,000 and $44,000, expect to shell out taxes on up to 50% of your benefits. Beyond $44,000, up to 85% of your Social Security income may be subject to taxes. 

However, if you and your spouse file your tax returns separately, you may not receive any tax credits. Now, if you don't have any other income outside of your social security, this will shield you from paying any taxes on your retirement benefits. It's also important to keep accurate financial records, such as check stubs, for all sources of income, as this can help ensure you're taking full advantage of tax credits and deductions available to you.

Taxes on social secuirty benefits? Social Security is exempt from state tax when you live abroad.

Taxes on IRAs and 401(k)s and other Qualified Accounts

IRAs are individual retirement accounts. By themselves, they aren't investment plans. Instead, they are used to hold assets such as stocks, mutual funds, and corporate bonds. On the other hand, 401(k)s are employer-sponsored tax-free retirement plans where your company automatically deducts your contributions and invest these in your chosen funds. Both retirement accounts are tax-deferred, allowing you to make making pre-tax contributions and decrease your taxable income. This means your money keeps growing tax-deferred while it's still within either plan. 

Note that if you cash these plans prematurely, you will have to pay a 10% early withdrawal penalty. Upon the mandatory retirement age of 59½, you can start making withdrawals without any penalty. The investments you made, and the subsequent gains, will be taxed at that point as ordinary income. When you hit age 72, you must make a required minimum distribution or RMD (withdrawal) from your retirement plans every year to avoid tax penalties. The government designed it this way to ensure that you will eventually pay your taxes. However, most people are in lower tax brackets at older ages.

Taxes on Annuity Income

An annuity is a standard insurance product that can be another investment strategy for retirees. Annuities will make regular payments to you either immediately or at some point in the future.

The insurance company collects a single premium from you, and it grows tax-deferred, based on an interest rate - sometimes the interest rate is based on market performance (indexed annuity), but your money is not actually in the market. Deferred variable annuities, however, are invested in the market and, as such, could face investment losses, whereas other annuities are sheltered from losses. 

Since annuities are tax-deferred, the earnings compound over time; because annuities are already tax-deferred, you would generally not have one inside a tax-qualified retirement account (IRA, 401(k), etc.). If the annuity is not inside a qualified account, you can invest as much money as you want for retirement. 

Annuities can create a guaranteed stream of income when you annuitize the account. Unless the annuity exists inside a qualified account, there would be no required minimum distributions (RMDs). If you make withdrawals before age 59½, you may be subject to a 10% IRS penalty.

When you start to receive income from the annuity (annuitize), you receive a set of payments as income, ensuring that you will never run out of money or not have income coming in.

Although annuities allow joint ownership and don't apply restrictions on the amount of contribution and distribution, they can cost more than IRAs at the outset because of higher fees and other administrative expenses. However, if you are a conservative investor, you don't have to worry about the risk of loss (unless it is a variable annuity that is actually invested in the market).

How your annuity distributions are taxed depends on how you paid for them. If you have a non-qualified annuity or one that's funded with post-tax dollars (meaning you already settled the necessary income taxes). You'll no longer owe any taxes on the contributions you made. However, taxes will be due on the gains from the annuity.

If you paid with pre-tax dollars, you have a qualified annuity, which means taxes will be imposed on any distributions or income upon the maturity of the pension plan and not before. The pre-tax period allows you to keep more of your money in the insurance product as your fund continues to grow tax-free.

It is usual for retirees to move to another state to be closer to family. However, they may also want to consider the different tax rules of each state as another substantial reason to change residences.

Inheritance and Estate Taxes

Inheritance and estate taxes are often interchanged, yet, they are markedly different. Currently, there are only six states with inheritance levies. You will need to pay inheritance taxes if your deceased benefactor lives in any of these states: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. If they don't, that's good news for you, especially because the federal government does not tax inheritance of any kind.

As for estate taxes (both state and federal), heirs aren't responsible for paying them. Instead, these are paid directly by the estate after the decease of the estate owner. Although tax rules vary from state to state, regardless of where you live, the government imposes a 40% federal estate tax on the portion of any property that goes beyond $12.6 million ( or $23.4 million for a married couple as of 2021). For 2022, the federal personal estate tax exemption amount is $12.06 million (it is $11.7 million for 2021). These taxes mean a large percentage of the wealth that you've worked so hard to build may not end up being enjoyed by your loved ones depending on the size of your estate.

If you're a high net-worth individual, you may want to protect your heirs by looking into tax-efficient charitable trusts, such as a charitable lead annuity trust or charitable remainder unitrust. The government encourages philanthropic donations through these trusts by giving donors substantial tax breaks on their contributions.

Tax Breaks

There are tax breaks that are available that can be helpful in retirement. If you have a Health Savings Account that money continues to grow tax-free forever, and the funds come out tax-free if they are used to pay for qualified medical expenses and some insurance premiums like Long-Term Care Insurance - IRS Reveals 2022 Long-Term Care Tax Deduction Amounts and HSA Contribution Limits | LTC News

The Bottom Line

Learning about the impact of taxes on your retirement income can help you project how much you need to live comfortably in your sunset years. This will motivate you to develop better tax-efficient savings and investment strategies to help secure your future and that of your loved ones. Find out more from your estate and financial planning advisors today.