Retirement

10 Questions Retirees Often Get Wrong About Taxes in Retirement

You worked hard for your retirement nest egg, so the idea of paying taxes on those savings isn't exactly appealing. If you know what you're doing, you can avoid overpaying Uncle Sam as you start collecting Social Security and making withdrawals (including RMDs) from IRAs and 401(k)s. Unfortunately, though, retirees don't always know all the tax code ins and outs and, as a result, end up paying more in taxes than is necessary. For example, here are 10 questions retirees often get wrong about taxes in retirement. Take a look and see how much you really understand about your own tax situation.

(And check out our State-by-State Guide to Taxes on Retirees to learn more about how you will be taxed by your state during retirement.)

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Tax Rates in Retirement

Question: When you retire, is your tax rate going to be higher or lower than it was when you were working?

Answer: It depends. Many people make their retirement plans with the assumption that they'll fall into a lower tax bracket once they retire. But that's often not the case, for the following three reasons.

1. Retirees typically no longer have all the tax deductions they once did. Their homes are paid off or close to it, so there's no mortgage interest deduction. There are also no kids to claim as dependents, or annual tax-deferred 401(k) contributions to reduce income. So, almost all your income will be taxable during retirement.

2. Retirees want to have fun—which costs money. If you're like many newly retired folks, you might want to travel and engage in the hobbies you didn't have time for before, and that doesn't come cheap. So, the income you set aside for yourself in retirement may not be much lower than what you were making in your job.

3. Future tax rates may be higher than they are today. Let's face it…tax rates now are low when viewed in a historical context. The top tax rate of 37% in 2021 is a bargain compared with the 94% of the 1940s and even the 70% range as recently as the 1970s. And considering today's political climate and growing national debt, future tax rates could end up much higher than they are today.

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Taxation of Social Security Benefits

Question: Are Social Security benefits taxable?

Answer: Yes. Depending on your "provisional income," up to 85% of your Social Security benefits are subject to federal income taxes. To determine your provisional income, take your modified adjusted gross income, add half of your Social Security benefits and add all of your tax-exempt interest.

If you're married and file taxes jointly, here's what you'll be looking at:

  • If your provisional income is less than $32,000 ($25,000 for singles), there's no tax on your Social Security benefits.
  • If your income is between $32,000 and $44,000 ($25,000 to $34,000 for singles), then up to 50% of your Social Security benefits can be taxed.
  • If your income is more than $44,000 ($34,000 for singles), then up to 85% of your Social Security benefits are taxable.

The IRS has a handy calculator that can help you determine whether your benefits are taxable. You should also check out Calculating Taxes on Social Security Benefits.

And don't forget state taxes. In most states (but not all!), Social Security benefits are tax-free.

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Withdrawals from Roth IRAs

Question: Are withdrawals from Roth IRAs tax-free once you retire?

Answer: Yes. Roth IRAs come with a big long-term tax advantage: Unlike their 401(k) and traditional IRA cousins—which are funded with pretax dollars—you pay the taxes on your contributions to Roths up front, so your withdrawals are tax-free once you retire. One important caveat is that you must have held your account for at least five years before you can take tax-free withdrawals. And while you can withdraw the amount you contributed at any time tax-free, you must be at least age 59½ to be able to withdraw the gains without facing a 10% early-withdrawal penalty.

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Taxation of Annuity Income

Question: Is the income you receive from an annuity you own taxable?

Answer: Probably (at least for some of it). If you purchased an annuity that provides income in retirement, the portion of the payment that represents your principal is tax-free; the rest is taxable. The insurance company that sold you the annuity is required to tell you what is taxable. Different rules apply if you bought the annuity with pretax funds (such as from a traditional IRA). In that case, 100% of your payment will be taxed as ordinary income. In addition, be aware that you'll have to pay any taxes that you owe on the annuity at your ordinary income-tax rate, not the preferable capital gains rate.

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Age for Starting RMDs

Question: At what age must holders of traditional IRAs and 401(k)s start taking required minimum distributions (RMDs)?

Answer: Age 72. The SECURE Act raised the age for RMDs to 72, starting on January 1, 2020. It used to be 70½. (Note that, although the CARES Act waived RMDs for 2020, they're back for 2021 and beyond.)

As for the amount that you are forced to withdraw: You'll start out at about 3.65%, and that percentage goes up every year. At age 80, it's 5.35%. At 90, it's 8.77%. Figuring out the percentages might not be as hard as you think if you try our RMD calculator. (Note that, beginning in 2022, RMD calculations will be adjusted so that distributions are spread out over a longer period of time.)

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RMDs From Multiple IRAs and 401(k)s

Question: Are RMDs calculated the same way for distributions from multiple IRAs and multiple 401(k) plans?

Answer: No. There's one important difference if you have multiple retirement accounts. If you have several traditional IRAs, the RMDs are calculated separately for each IRA but can be withdrawn from any of your accounts. On the other hand, if you have multiple 401(k) accounts, the amount must be calculated for each 401(k) and withdrawn separately from each account. For this reason, some 401(k) administrators calculate your required distribution and send it to you automatically if you haven't withdrawn the money by a certain date, but IRA administrators may not automatically distribute the money from your IRAs.

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Due Date for Your First RMD

Question: Do you have to take your first RMD by December 31 of the year you turn 72?

Answer: No. Normally, you have to take RMDs for each year after you turn age 72 by the end of the year. However, you don't have to take your first RMD until April 1 of the year after you turn 72. But be careful—if you delay the first withdrawal, you'll also have to take your second RMD by December 31 of the same year. Because you'll have to pay taxes on both RMDs (minus any portion from nondeductible contributions), taking two RMDs in one year could bump you into a higher tax bracket.

It could also have other ripple effects, such as making you subject to the Medicare high-income surcharge if your adjusted gross income (plus tax-exempt interest income) rises above $88,000 if you're single or $176,000 if married filing jointly. (Note: Those are the income thresholds for determining 2021 surcharges.)

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Taxation of Life Insurance Proceeds

Question: If your spouse dies and you get a big life insurance payout, will you have to pay tax on the money?

Answer: No. You have enough to deal with during such a difficult time, so it's good to know that life insurance proceeds paid because of the insured person's death are not taxable.

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Estate Tax Threshold

Question: How valuable must an individual's estate be at death to be hit by federal estate taxes in 2021?

Answer: $11.7 million ($23.4 million or more for a married couple). If the value of an estate is less than the threshold amount, then no federal estate tax is due. As a result, federal estate taxes aren't a factor for very many people. However, that will change in the future. The 2017 tax reform law more than doubled the federal estate tax exemption threshold—but only temporarily. It's schedule to drop back down to $5 million (plus adjustments for inflation) in 2026. Plus, during his 2020 campaign, President Biden called for a reduction of the exemption threshold sooner.

If your estate isn't subject to federal taxes, it still might owe state taxes. Twelve states and the District of Columbia charge a state estate tax, and their exclusion limits can be much lower than the federal limit. In addition, six states impose inheritance taxes, which are paid by your heirs. (See 18 States With Scary Death Taxes for more details.)

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Standard Deduction Amounts

Question: If you're over 65, can you take a higher standard deduction than other folks are allowed?

Answer: Yes. For 2021, to the standard deduction for most people is $12,550 if you're single and $25,100 for married couples filing a joint tax return ($12,400 and $24,800, respectively, for 2020). However, those 65 and older get an extra $1,700 in 2021 if they're filing as single or head of household ($1,650 for 2020). Married filing jointly? If one spouse is 65 or older and the other isn't, the standard deduction increases by $1,350 ($1,300 for 2020). If both spouses are 65 or older, the increase for 2021 is $2,700 ($2,600 for 2020).

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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