Taxes in Retirement

State income tax laws vary dramatically across the U.S. Some states have no income taxes, other states tax retirement benefits less than working income, and still others treat retirement benefits no differently than working income. But income taxes shouldn’t be your only consideration when contemplating where to live during retirement. You should also take into account property taxes, sales taxes, cost of goods and services, proximity to family, access to entertainment and services, and many other considerations.

Many forms of retirement income are taxed at the federal income level:

• Before-tax 401(k) contributions
• Employer matching contributions
• Employer discretionary contributions
• Most pension income
• Part of your Social Security benefits

Tax-free sources of retirement income include:

• Roth 401(k) contributions
• Qualifying Roth distributions
• Part of your Social Security benefits

Although Social Security benefits may be partially taxable depending on your income level and federal income filing status, under current law you will always receive at least 15% of your benefit federal income tax-free.

Saving on income taxes requires three things:

• Opportunity. Some individuals are unable to reduce their tax bill because their retirement expenses, income, and tax rate are forecasted to be consistent throughout retirement.
• Pre-planning. Even if you have an opportunity to save on taxes, you may not be able to claim those savings if you don’t work with a qualified tax advisor who can help you arrange transactions properly.
• Proper reporting. Finally, you must accurately report the strategy on your tax return and keep appropriate records to realize the benefit of the strategy.

Income tax rates in retirement are determined just like they are in pre-retirement years. Generally, total income may be adjusted and is offset by deductions (standard or itemized). After adjustments, your income falls within a tax bracket indicating the rate at which your income will be progressively taxed.

The list of tax deductions and credits available to retirees is generally the same as for employees. Some exceptions include a higher standard deduction for those older than 65 and, in some cases, the credit for the elderly or the disabled.

How much retirement income you receive and from what sources may affect the deductions or credits you qualify for.

In the U.S., Congress controls federal tax laws. For individuals, this includes income, estate, payroll (FICA/FUTA), and gift taxes. When you are retired and no longer have employment income, you generally no longer pay payroll taxes (7.65%, currently).

Although we don’t know what Congress will do in the future, historically tax initiatives and incentives are generally oriented toward lowering income taxes for average Americans, not raising them. Instead of worrying about unknown future tax law changes, it’s best to work with competent tax professionals to evaluate your holistic tax outlook and take advantage of current tax rules and best practices.

Charitable contributions are itemized deductions for federal income tax purposes, which means if you take a standard deduction you won’t get a tax benefit for those donations. Once you reach age 70.5, you can make qualified charitable distributions (QCDs) from most individual retirement accounts (IRAs). These are non-taxable distributions as opposed to itemized deductions. Current tax law does not allow QCDs from 401(k) plans.

The decision of traditional or Roth 401(k) contributions can be an important part of retirement planning. If you choose traditional (or “before-tax”), you’ll save on taxes now but will be taxed on retirement distributions. If you choose Roth, you won’t get any tax break now, but you will not pay taxes on retirement distributions (assuming retirement is after age 59.5 and five years from the first Roth contribution).

Generally, traditional contributions are better when you anticipate that your marginal tax rate will be lower in the future. Roth contributions are preferred if you anticipate that your marginal tax rate will be higher in the future.

We encourage those who use traditional contributions to save the tax savings they get from their contributions, rather than using traditional contributions to increase disposable income.

While contribution type is an important decision, it isn’t the most important decision when it comes to saving for retirement. Your overall contribution rate and investment allocation, for example, are typically more critical decisions.