Are there taxes in retirement?
Yes. Thanks for coming. Tip your servers. Safe drive home. Good night!
Seriously, many people believe there are no taxes in retirement. It would be wonderful if that were true. However, those who have done a great job with their 401ks and IRAs over the years and are looking at living for decades in retirement, well, they may end up paying more in taxes in retirement.
Now, is it possible to not pay any taxes in retirement? Yes, however, it is difficult and, more importantly, odds are you will be in a worse financial position than if you had just paid some taxes over time. To achieve a no tax retirement you would most likely have to do some combination of IRA to Roth conversion (requires taxes paid at conversion), structure some muni bonds (for a limited period) and hope like hell tax laws do not change down the road. This final point is the big unknown and totally out of your control. Let’s review some of the high points when it comes to a few components that make up your taxes in retirement.
Social Security was initially set up to be tax-free. In 1984 some changes went into effect that made it possible to tax some benefits. Now, if your only source of income in retirement is Social Security, it is entirely tax free. Most people have other sources of income in retirement and the total amount of taxes depends on the cumulative income, which does include Social Security. There are multiple steps to determine how much of your Social Security will be taxed, but you need to start by calculating your provisional income.
Provisional income is your AGI (adjusted gross income), tax-exempt interest and ½ of your Social Security. Your provisional income determines what percentage of your Social Security benefit will be added to your other sources of taxable income. After you have calculated provisional income, you can then start calculating how much of your Social Security is taxed. Clear, right? The IRS does have a form to help you calculate this and it’s only 4 pages in length.
RMDs are every retiree’s favorite topic. Required Minimum Distributions have been covered in other articles, however, as a refresher, it is basically when Uncle Sam says while he appreciates you took advantage of tax laws to save for retirement, it is time for him to get his share back. RMDs are calculated by the total value in your IRAs and a handy little divisor provided by an IRS longevity table. Let’s make a simple example where you have $1,000,000 in your IRAs and you are expected to live another 25 years. You divide $1,000,000 by 25 and get $40,000. This is your RMD for that year and you really want to take it, otherwise you have a 50% penalty on it. Once you take your $40,000 out Uncle Sam will tax this as ordinary income. He doesn’t care if you spend the rest, as long as you pay taxes on it. Remember, your divisor decreases every year as you get one year older. Now, you could always do a Roth conversion with that $1,000,000 in IRAs to reduce taxes down the road. However, you had better prepare for a hell of a tax bill when you do a conversion of that amount!
Another element retirees deal with are taxes related to capital gains. This is where you pay taxes, possibly at a reduced rate, on investments that have gone up in value. It also includes real estate. Here is where most people get turned around when it comes to capital gains in retirement. Capital gains are included in your AGI calculation. So, not only could you bump up your tax rate on capital gains payments but also on what you pay in Social Security taxes.
Fun stuff, right? So, taxes do exist in retirement. The best defense to minimize your retirement taxes is to stay proactive and do proper tax planning with your CPA. As we all know, there are only two certainties in life – death and taxes.