One piece of advice we give our clients at Keen Wealth Advisors is to make a financial plan that attempts to minimize surprises in retirement.
Without a plan, many retirees get their first big surprise in the second week of April. And it’s not a fun surprise: when you stop receiving a paycheck and start living off your assets and investments, your tax filings can change dramatically.
Here are six common sources of income for retirees, and the tax issues unique to each. It may be helpful for you to meet with a tax advisor so you understand how these assets could turn into liabilities if you aren’t prepared for the tax ramifications.
1. Social Security
You probably won’t pay taxes in retirement if you’re living off Social Security alone. But if you generate income from other investments and assets (or maybe you have a fun job that generates some extra cash) and meet certain thresholds, then part of your Social Security income is taxable. Depending on your combined income, up to 85% of your Social Security benefit may be subject to taxation. Some people even find that their combined income including Social Security is higher when they are retired than when they were working, and this might put them in a higher tax bracket.
If you have purchased an annuity with pretax funds from another retirement account, like an IRA, then withdrawals are taxable.
In an immediate annuity, you only have to pay taxes on what’s considered the interest portion of the withdrawal.
Fixed or variable annuities require that you withdraw all your earnings first, and pay taxes on those earnings, before withdrawing your original contributions tax-free.
Let me add this--taxes on annuities can get complicated quickly so make sure you seek professional advice.
Any pre-tax money you paid into a pension will be taxable upon withdrawal. Since most pensions are funded with pre-tax income, most people have to pay taxes on their entire annual pension income. In cases where pensions were funded after-tax, then only a portion of that pension income is taxable. But, as mentioned when discussing Social Security, a generous pension, combined with income from your other assets, could end up bumping a portion of your income into a higher tax bracket. High earners need to be careful about structuring their other retirement investments to avoid a tax hike and paying more taxes in retirement.
While you were working, you paid taxes on capital gains, income from interest, and dividends. That doesn’t change on your taxes in retirement -- your financial institution should send you a 1099 like they always have. But you can manage your capital gains and losses on investments outside of your retirement account through tax-loss harvesting and being aware of the holding periods on these investments. Assets held for over a year qualify for the lower long-term capital gains rate. If your retirement income is below a certain threshold, you may even qualify for a zero percent capital gains tax rate on those profits.
5. IRA and 401(k) Withdrawals
Everyone loves the Roth IRA because withdrawals are tax free if you paid taxes when you set it up. But there are rumblings in Washington about changing the Roth, and for some people, paying those taxes up front might be worse than paying taxes on withdrawals.
Most people are going to wind up paying taxes on IRA and 401(k) withdrawals, based on their income, deductions, and tax bracket. However, if you have more deductions than income for a given year, due to, say, extra medical costs or charitable donations, then your withdrawals for that year could end up tax exempt. It may even make sense to convert some of your traditional IRA to a Roth IRA in years such as this.
6. Home Gains
If you sell a house you’ve been living in for at least two years, you probably won’t have to pay taxes unless your gains are greater than $250,000 for a single filer, or $500,000 for married couples. Things get more complicated if you lived abroad for a long period of time, or used the house as a rental property. If this is your situation, let us know and we can look at it in more detail.
Your big picture is probably… still smaller.
By now you may be thinking, “I can’t afford to retire!”
Don’t worry. With proper and realistic planning, you can create a retirement plan that lays out the parameters that can work. Although, the key is to stay on top of it and keep it current.
For most people, income from assets and investments won’t move them into a higher tax bracket. Your total income in most cases will be lower than it was while you were working (at least until your required minimum distributions start to ratchet your income up), and you won’t be paying FICA anymore. The more thoughtful planning you do, the less your retirement taxes will end up surprising you.
Bill Keen is a CHARTERED RETIREMENT PLANNING COUNSELOR℠ and independent financial advisor with more than 25 years of industry experience. As the founder and CEO of Keen Wealth Advisors, a registered investment advisory firm, he specializes in providing personalized retirement planning designed to help people thrive before and during their retirement years. With a passion for educating others, Bill regularly blogs about retirement planning, hosts the podcast Keen on Retirement, and has contributed to U.S. News and World Report, Reuters, Wall Street Journal’s Market Watch, Yahoo Finance, and other publications. Based in Overland Park, Kansas, Bill and his team work with clients throughout the greater Kansas City area and across the nation. To learn more, connect with him on LinkedIn or visit www.keenwealthadvisors.com.
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