Planning for retirement. We spend most of our working career preparing for it, saving for it, covering every contingency. When you finally wave goodbye to the company, you’re ready for all that planning to take over. But does your planning take into account the taxes you’ll have to pay on your retirement income? It’s one of the biggest retirement planning mistakes people make.
Anqui Chen and Alicia H. Munnell at the Center for Retirement Research at Boston College analyzed data from the most recent federal Health and Retirement Study. They published their findings in a preliminary paper, How Much Taxes Will Retirees Owe on Their Retirement Income. Chen and Munnell say that retiree households will pay approximately 6 percent of their retirement income in federal income taxes. But the percentage varies depending on the level of income.
So, what gets taxed?
- Withdrawals from traditional IRAs
- Withdrawals from 401(k)s
- Withdrawals from 403(b)s
- Withdrawals from tax-deferred annuities
- Required Minimum Distributions (RMDs) from IRAs and retirement plans beginning at age 72
- Dividends and interest from non-retirement assets (stocks, bonds, mutual funds, etc.)
- Capital gains from the sale of non-retirement assets.
And yes, chances are good you’ll pay federal income taxes on your Social Security benefits. That comes as a surprise to many retirees. Approximately 40 percent of Social Security recipients pay taxes on their benefits and that number may go up.
According to IRS regulations, you’ll pay taxes on up to 50 percent of your Social Security benefit if you’re
- Single and have combined income between $25,000 and $34,000
- Filing a joint return and have a combined income between $32,000 and $44,000
You’ll pay taxes on up to 85 percent of your Social Security benefit if you’re
- Single with combined income above $34,000
- Filing a joint return and have a combined income above $44,000
Combined income equals your adjusted gross income plus nontaxable interest plus one-half of your Social Security benefits. Also, the income thresholds above are not indexed for inflation, so it’s expected that more and more households will be required to include 85 percent of their benefits for tax purposes.
Another retirement planning item that’s often missed is the Social Security Earnings Test. This is important if you plan to claim Social Security benefits before your full retirement age (currently between 66 and 67) and work part-time.
For those who claim benefits early, there is a Social Security earnings limit, which is the maximum you are allowed to make from employment without triggering a benefit reduction. In general, Social Security withholds $1 in benefits for every $2 you make above the annual earnings limit. That limit changes from year to year based on an inflation index. The earnings limit is based on earned income. Pensions, investment income, and other government benefits, such as unemployment compensation, do not count toward the earnings test.
There’s more to retirement planning than just how much income you’ll have coming in. Make sure you consider the income you’ll lose to taxes, including those states that tax retirement income, so you have an accurate picture of what you’ll really have to live on.