If you dread tax day every year, here’s a bit of good news:
Your tax burden probably will lighten when you retire.
You’ll still pay taxes on income you receive from sources
that haven’t been taxed yet, such as 401(k) and individual retirement accounts
or a defined benefit pension. Your Social Security benefits also may be taxed,
depending on your income. And higher-income seniors pay surcharges on Medicare
premiums that, while not technically taxes, certainly feel like it to retirees.
But for most households, tax rates fall in retirement,
according to research by the Investment Company Institute and the Internal
Revenue Service. “Some of the decline is due to the fact that you’re not making
payroll tax contributions, but income taxes tend to fall both because your
total income is typically lower and because only a portion of Social Security
is taxable,” said Peter Brady, senior economic adviser at the institute, a
trade group representing the asset management industry.
Careful planning can reduce your tax burden in retirement,
experts say. “Being efficient about taxes can have a pretty substantial
impact,” said Wade Pfau, an expert on retirement income and author of the
“Retirement Planning Guidebook.” “Especially if you have a large I.R.A., some
planning can really be helpful.”
Here are the key ways that income is taxed in retirement,
and some strategies that can help you be as tax-efficient as possible.
Social Security
Roughly half of Social Security beneficiaries pay federal
income taxes on a portion of their benefits. The tax affects retirees with
relatively higher incomes, but the proportion of people who owe taxes is
rising.
Taxation of benefits is triggered when certain types of
income exceed a threshold. The income formula used to determine this is called
“combined income” (also sometimes referred to as “provisional income”). It’s
the sum of your adjusted gross income, nontaxable interest and half of your
Social Security benefits.
If your combined income is equal to or below $25,000 (for
single filers) or $32,000 (for married filers), no tax is owed on your benefits.
Beneficiaries in the next tier of income — between $25,000
and $34,000 for single filers and between $32,000 and $44,000 for married
couples filing jointly — pay federal income taxes on up to 50 percent of their
benefits. Beneficiaries with income above those levels pay taxes on up to 85
percent of benefits.
Benefits were first taxed in 1984 as part of a reform
package signed into law the previous year aimed at stabilizing the program’s
finances — the revenue is credited to the Social Security and Medicare trust
funds.
The tax thresholds are not indexed for inflation, so more
retirees have found themselves paying taxes over the years — and many continue
to express frustration about it, said Ed Slott, a tax expert who often conducts
educational seminars for consumers and financial planners.
“I’m always getting asked why Social Security benefits are
taxed,” he said. “It’s been going on for decades now, but people still complain
about it.”
Each January, the I.R.S. will send you Form SSA-1099, which
shows the total amount of benefits you received from Social Security in the
previous year for purposes of reporting on your tax return. It’s also possible
to have taxes withheld from your benefits, by completing Form W-4V.
Tax-deferred income
The U.S. retirement system is structured to provide tax
advantages while you save.
Contributions by you and your employer to defined
contribution plans are excluded from taxable wages, and investment returns
earned on contributions are not taxed. These tax savings provide a powerful
benefit that helps your portfolio grow over time.
But income taxes are due when you draw down those dollars.
“Think of your I.R.A. as a joint account with Uncle Sam,
because that’s what it is,” Mr. Slott said. “Part of that money is owed back to
the government when you draw it in retirement — how much will depend on your
future tax rates.”
Most workers approach retirement with the bulk of their
savings in tax-deferred accounts. Americans held $37 trillion in retirement
assets in the third quarter of 2021, according to the Investment Company
Institute — and most of it is in defined contribution plans, I.R.A.s or defined
benefit pensions.
It can make sense to diversify your savings during the years
when you are saving to include a Roth I.R.A. or Roth 401(k). These accounts are
funded with after-tax dollars. No taxes are paid on withdrawals of contributed
amounts or investment gains, so long as two key rules on withdrawal are met.
First, you must be over 59½ years of age; second, your Roth account must have
existed for at least five years.
But from a tax perspective, the value of saving in
tax-deferred or Roth vehicles depends on your tax rates now and in the future.
“If your income tax rate is the same at the time when you contribute and
withdraw, it’s an equivalent outcome,” Dr. Brady said.
Medicare surcharges
Higher-income retirees pay surcharges on their premiums for
Medicare Part B (outpatient services) and Part D (prescription drugs). Formally
known as Income Related Monthly Adjustment Amounts, they can increase Medicare
costs substantially.
The Social Security Administration determines whether you
must pay a surcharge using the most recent tax return it can access from the
I.R.S. — generally two years before the year for which the premium is being
determined. This look-back feature means that the surcharge can be triggered
for middle-class workers in the early years of retirement, because it factors
in your final years of wage income.
There are five surcharge brackets, defined by your modified
adjusted gross income. Medicare enrollees falling into these brackets shoulder
a higher share of total program costs. While Medicare sets the standard Part B
premium each year to cover 25 percent of total program costs, those subject to
surcharge pay 35 percent to 85 percent of those costs.
This year, that translates to a Part B surcharge of $68 a
month for a retiree filing a single tax return with modified adjusted gross
income between $91,000 and $114,000. Her total premium is $238.10, instead of
$170.10. The Part D surcharge is smaller — $12.40 this year for seniors falling
into the first bracket.
From there, the surcharge levels jump substantially. And,
there’s nothing graduated about them, Mr. Slott notes. “I call it a cliff — if
you’re one dollar over, you’re paying the full amount.”
The current high rate of inflation will help some Medicare enrollees
avoid surcharges, since the bracket definitions are adjusted annually for
inflation. “It does look like we’ll have fewer people paying the surcharges,”
said Ron Mastrogiovanni, chief executive of HealthView Services, a Boston-area
maker of health care cost-projection software.
The two-year lag effect can create unpleasant surprises when
you first enroll in Medicare. It is possible to appeal premium surcharges if
your income declined owing to any one of a number of defined “life-changing”
circumstances — and one of those is stopping work. File your appeal using Form
SSA-44 from the Social Security Administration.
State taxes
Many states exempt retirement income, although the specifics
vary widely. Eight states have no personal income tax, but among those that do,
about three-quarters fully exempt Social Security benefits from taxation, and
most others have partial exemptions for lower-income retirees, according to
research by the Institute on Taxation and Economic Policy, a nonpartisan
nonprofit group. Many states also have partial or full exemptions for pension
income, and extra personal exemptions or reductions.
“It’s very common for some part of pension income to be
exempted at the state level,” said Aidan Davis, the group’s acting state policy
director. “And we’re seeing a major trend this year with more states cutting
taxes for retirees,” she added.
Strategies for tax efficiency
Careful planning before retirement can help minimize or even
avoid some of the knock-on effects that taxes on Social Security and Medicare
surcharges can create. The objective is to reduce taxable income wherever
possible by diversifying your holdings outside tax-deferred accounts.
Saving for retirement in a Roth I.R.A., or a Roth 401(k)
offers one path to achieve this goal, as can Roth conversions, especially in
the early years of retirement before you claim Social Security.
For workers enrolled in high-deductible health insurance
plans, a Health Savings Account can help. These accounts can be used to pay
out-of-pocket health care costs in retirement; contributions are
tax-deductible, and investment growth and interest are tax-exempt, as are
withdrawals spent on qualified medical expenses. Contributions to these
accounts generally must stop six months before your Medicare enrollment becomes
effective.
Making charitable contributions from an I.R.A. also can make
sense. If you are at least age 70½, you can donate up to $100,000 annually to
charities using Qualified Charitable Distributions. No income taxes are due on
these distributions, and they also count against your annual required minimum
distributions.
This is an especially attractive strategy for retirees who
do not itemize deductions on their tax returns, Dr. Pfau said. That often is
the case, since seniors typically have fewer deductions, and their standard
deduction is somewhat higher (for the 2021 tax year, a single-filing taxpayer
age 65 and over can add $1,700 to the standard deduction of $12,550).
“Since these distributions don’t count in your adjusted
gross income, they can help with things like Medicare surcharges and taxation
of Social Security benefits,” he said.
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