Top 3 Tax Surprises in Retirement

Taxes–federal, state, local, sales tax, property tax, gasoline tax, payroll tax, tolls, fees, taxes on capital gains, dividends and interest, gift tax, inheritance tax, and cigarettes and alcohol. There has even been a rising chorus that is calling for a special tax on junk food.  We can’t escape taxes.

If you have already retired, you are aware that taxes don’t end when retirement begins. For those who are nearing retirement, taxes can be a big surprise after the first year of retirement if you haven’t planned ahead.  Below I’ve outlined the top 3 surprises associated with taxes in retirement:

Estimated quarterly tax payments may be required

If you have never been self-employed, you are accustomed to having federal, state, and payroll taxes withheld from each paycheck.  When you stop working, there are no more W-4s to complete and no one is withholding taxes for you. But that doesn’t absolve you of your year-end tax liability.

You can make estimated payments each quarter and/or you can also have taxes withheld from your pension, social security, or IRA distribution.

If you have yet to file for social security, you may choose to have Social Security withhold 7%, 10%, 12% or 22% of your monthly benefit for taxes. You can also have 10% or more withheld from IRA distributions.  If you don’t withhold enough, estimated quarterly payments will be required.   

Social security may be taxed

If you file as an individual and your combined income (adjusted gross income + nontaxable interest + half of your Social Security benefits) is between $25,000 and $34,000, you may have to pay income tax on up to 50% of your benefits. If the total is more than $34,000, up to 85% of your benefits may be taxable.

If you file a joint return and you and your spouse have a combined income that is between $32,000 and $44,000, you may have to pay income tax on up to 50% of your benefits. If combined income is more than $44,000, up to 85% of your benefits may be taxable. (SSA.gov Benefits Planner: Income Taxes and Your Social Security Benefits).

Beware of the required IRA minimum distribution or RMD

 RMDs are minimum amounts that retirement plan account owners must withdraw annually starting with the year they reach 70½ years of age.   The RMD rules also apply to SEP IRAs and Simple IRAs, 401(k), profit-sharing, 403(b), 457(b), profit sharing plans, and other defined contribution plans.  Distributions are not required from a Roth IRA.

If you expect to have large RMDs that could push you into a higher tax bracket, it may be beneficial to begin taking distributions prior to 70½. Or, you could convert some of your IRA into a Roth, which will help shelter gains and future distributions from taxes. You pay a tax upfront, but it’s one strategy that can help minimize taxes long-term.

This is a high level summary designed to educate and avert surprises. Planning for tax outlays doesn’t reduce the discomfort that goes with paying Uncle Sam. But preparation can aid in our understanding and eliminate unexpected surprises.

Feel free to reach out to us with specific questions, or consult with your tax adviser.