What Retirees Often Get Wrong About Taxes

As a leading estate planning attorney servicing residents throughout Montgomery County and beyond, Slutsky Elder Law understands that you have worked hard for your nest egg, and the idea of paying taxes on them isn’t exactly appealing. However, you can avoid overpaying as you begin collecting Social Security and making withdrawals from IRAs and 401(k)s. Unfortunately, most retirees don’t have an intimate understanding of the tax code’s many ins and outs. As a result, they end up paying more than necessary.


Frequently Asked Questions: Retirement and Taxes

To help you get a better understanding of your own retirement and tax situation, we’ve compiled some common concerns:

When I retire, will my tax rate be higher or lower than when I was working?

It depends. Many make their retirement plans with the assumption they will fall into a lower tax bracket come retirement. However, that may not be true:

 

Retirees no longer have the tax deduction they once did. Their homes are fully or close to being paid off, so there is no mortgage interest deduction. There are no kids to claim as dependents, or annual tax-deferred 401(k) contributions to reduce income. Nearly all of your income will be taxable during retirement.

 

Retirees, understandably, want to have fun. If you’re like many new retirees, 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 funds you withdraw from your tax-deferred retirement plans (at least early in retirement) may not be much lower than what you earned while working.

 

Future tax rates could be higher than they are today. The top marginal income tax rate of 37% in 2020 is a bargain compared to the 94% of the 1940s and even the 70% range in the 1970s. And considering today’s federal deficit and the deficits many states are running, income taxes and what is taxed in retirement is likely to be higher than it is today.

Are Social Security benefits taxable?

Up to 85% of these benefits are federally taxable, but it all depends on your provisional income. Add your gross income, tax-free interest, and 50% of Social Security benefits to determine your provisional income.

 

If you are married and file taxes jointly:

  • If your provisional income is under $32,000 ($25,000 for singles), your Social Security benefits have no tax.
  • If you make between $32,000 and $44,000 ($25,000 to $34,000 for singles) per year, up to half of your Social Security benefits can be taxed.
  • If your income exceeds $44,000 ($34,000 for singles), up to 85% of your Social Security benefits are taxable.

It’s important to note that these amounts have not been indexed for inflation since the introduction of the tax in 1984. Therefore, the amount being taxed is much higher than it used to be since benefits have increased a great deal.

Are Roth IRA withdrawals tax-free once I retire?

Yes. Unlike their 401(k) and traditional IRA counterparts — which are funded with pretax dollars — you pay the taxes on your contributions to Roths upfront, so your withdrawals are tax-free once you retire. One must hold their account for at least half a decade before being able to take tax-free withdrawals. While you may withdraw your contribution amount at any time tax-free, you must be at least 59½ to withdraw the gains without facing a 10% early-withdrawal penalty.

Is the income I receive from an annuity I own taxable?

It depends. Withdrawal of the portion of the payment that represents your principal is tax-free; the rest (the income) is taxable at regular income tax rates (unlike investments outside of annuities and other retirement plans which may be taxed at lower capital gains rates). If you purchase the annuity with pretax funds (like from a traditional IRA), all of your payment will be taxed as income.

When must holders of traditional IRAs and 401(k)s begin taking Required Minimum Distributions (RMDs)?

It used to be 70½, although the SECURE Act raised the age for RMDs to 72. However, for those born before July 1, 1949, the age is still 70½. It’s important to note The CARES Act waived RMDs for 2020.

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

No. If you have several traditional IRAs, RMDs are calculated separately according to each IRA but can be withdrawn from any accounts. If you have more than one 401(k) account, the amount must be calculated for each and withdrawn separately. Due to this, some 401(k) administrators calculate your required distribution and automatically provide you with it if you have not withdrawn funds by a specific date. Still, IRA administrators may not automatically distribute money from your IRAs.

Do I have to take my first RMD by December 31 of the year I turn 72?

No. Typically, you have to take RMDs for each after you turn 72 by the end of the year. However, you wouldn’t have to take your first RMD until April 1 of the year after you turn 72. Be careful — if you delay this initial withdrawal, you’ll have to take your second RMD by December 31. Since you’ll have to pay taxes on both (minus any portion from nondeductible contributions), taking two in the same year could bump you into a higher tax bracket.

 

It could also subject you to the Medicare high-income surcharge if your adjusted gross income (in addition to tax-exempt interest income) exceeds $87,000 if single or $174,000 if married and filing jointly.

Will I have to pay tax if my spouse dies and I get a sizable life insurance payout?

No. Life insurance proceeds paid in the event of an insured individual’s death are not income taxable. However, they may be federal-estate taxable if the estate is big enough OR if the state in which you reside taxes life insurance proceeds (Pennsylvania does not).

For more information about how our top-rated elder law attorney in Chester County can help navigate you and your finances through retirement, contact Slutsky Elder Law today!