You envision retirement as escape from the stresses of work to enjoy doing what you love. So you’ll think it cruel to learn that taxes in retirement dog you just as in your work years. Here’s how to prepare for and minimize the bite.
Federal taxes on retirement accounts
When you surpass age 59 and a half and start to draw money from any private retirement savings such as a 401K, or Individual Retirement Account (IRA), the amount you draw per year is subject to federal income taxes. Only a Roth IRA is not subject to federal taxation among private plans.
Once you are eligible to draw Social Security, it is taxed at tiered levels depending on your overall income for the year. For a single person if combined income is under $25,000 his SS is not taxed; between $25,000 and $34,000 half of it is taxed and over $34,000 subjects 85 percent of SS income to tax. For married couples the 50 percent tier is $32,000 to $44,000 and 85 percent starts after that.
Let’s clear up a potential confusion: SS income is not taxed at a rate of 50 percent or 85 percent. Those are the percentages of SS income subject to taxation. The tax rate itself depends on which bracket total income falls.
Even if you hold off tapping into your private retirement accounts, at age 70 and a half the IRS requires you to begin taking money out, known as the required minimum distribution. When that happens, the amount taken, combined with any other income, including Social Security, will determine your overall federal tax picture.
Beware of state taxes
Depending on where you live, state taxes may have a big impact. Each state has its own taxation schedule on retirement accounts and some have none. If you’ve always dreamed of retiring to one state that has caught your fancy, do your due diligence to learn the state tax picture there before making the move.
Seven states offer the best tax picture in that they do not have a state income tax. Your money will be protected from state income tax in Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. Some of these states make up for the lack of state income tax with higher property taxes or state sales taxes. However, some states extend caps and exemptions on property taxes to people over a certain age, such as 65.
One thing to note, however, is that under the new federal tax rules for 2018, the amount of state and local taxes that a taxpayer can deduct has been capped at $10,000. Previously a taxpayer could claim whatever amount of state income tax, property tax or state sales taxes were paid. A taxpayer who paid $19,000 in state and local taxes prior to 2018 could claim it all. Now only $10,000 is deductible.
Several states subject retirement income to state income tax and some states even tax Social Security income. There is a lot of variation, so it is important to research any state in which you are considering. With retirement income subject to federal taxation, you want to avoid a double whammy by being hit hard at the state level too.
Other taxes are the same as before retirement
Other taxes which you faced before retiring do not change. For example, if a home is sold for a capital gain and the owner meets the requirements of owning the house at least two years and lived in it for two of the last five years, individuals can make a capital gain of $250,000 free of taxes and married couples filing jointly can take a $500,000 gain.
The federal amounts exempt from estate taxes were dramatically raised in the 2018 tax law change, to just over $11 million per individual and $22 million for couples.
However, several states impose some level of estate taxes, and it varies from state to state, with much lower thresholds amounts subject to estate taxes than the federal thresholds. Some states having no inheritance taxes. Again, contact a tax professional and research your own state or any other state to which you are considering a move before making the commitment. Once again, you could make the mistake of thinking the generous exemption cap of the federal tax law means no estate tax is due, only to be shocked by your state taking a big bite.