How Much Will I Pay in Taxes in Retirement?
If you’re thinking about retirement, you may ask yourself this question. Maybe it occurred to you that taxes will be due in retirement, and a lot of the onus is on you to pay them. As an employee, you never had to think about paying taxes because they are automatically taken out of your paycheck. You’re probably starting to wonder how much will I pay in taxes in retirement.
When I think about how much will I pay in taxes in retirement, I’m reminded of a video I saw recently. A young man is with his family and some friends. He is so excited because he just got his very first paycheck. Everyone is anxious as he opens the envelope. The anticipation is evident on his face. He has been waiting for the day when he can cash his first earnings check. He opens the envelope, looks at the number, and slumps back in his chair. It’s clear by the look on his face that the amount he made is not the same as what he’s going to take home. He has a silent partner in earning income that he hasn’t counted on.
Taxes must be paid, and your gross pay or total income does not represent what you get to spend. We all have the same silent partner. Uncle Sam. When it comes to retirement, sometimes I find clients can feel a little bit like that young man. They think, “I will have all this income when I retire.” They, too, sometimes slump in the chair when realizing Uncle Sam still wants his cut.
The nice thing with retirement income is that you don’t have to worry about Social Security and Medicare taxes because retirement income generally does not come with that. However, there’s still the federal income tax. There might also be state income taxes if you live in a state with income taxes.
For example, many of my clients are Disney leaders, Cast Members, Imagineers and employees. Florida employees do not pay income tax because the state doesn’t have the required income tax. Employees in California are obligated to pay income tax. This means that each person will have a different consideration for how much taxes will I pay in retirement based on where one lives.
Three Steps to Identify Retirement Taxes
1) How much income do you need?
The answer to this is specific to your situation. I’ve discussed this topic in another article that you may want to read through to help you gain insight. The basic idea is that you want to figure out how much income you need on a net basis to cover your monthly expenses. This includes traveling, living expenses, health care, etc. Add all your expenses to determine how much income you need to live on.
2) Where is the money going to come from?
If you determine that you need $5,000, $10,000, or $2,000 per month, where will it be sourced from? Is it going to come from Social Security alone? Maybe part of it is Social Security, and part is from a pension. Do you have cash in savings and checking accounts available? You may be planning to use a mix of things like an IRA, 401K, annuities, stocks, and mutual funds.
There are many ways to generate retirement income. If you know you will need $80,000 yearly, you need to understand where the income will be generated. Very rarely do I find a client with one retirement income source. Usually, in retirement, it comes from multiple sources. This leads us to step number three.
3) How is that source of income taxed?
This is more complex since various income sources are taxed differently. This is a mindset shift from when you’re working to when you’re retired because your income as a wage earner is treated pretty much the same unless you have some stock compensation. There are some nuances there.
For the average person, going from a wage earner to a retired person, the source of income now matters. This is especially true if you have savings outside of just being able to claim a pension or social security.
Up to 85% of Social Security can be taxed and is considered ordinary income. Pensions are also ordinary income. Ordinary income is what your typical tax bracket is going to be. You may be in the 12% or 20% bracket. It will also change from time to time since tax laws change.
Having a Roth account means it comes out tax-free, provided you meet the stipulations of the Roth rules. Yes, there are some rules to be aware of with Roth distributions or withdrawals from a Roth account.
Maybe you have invested in company stock over the years. If you plan to use that for income, it will be taxed differently because of potential capital gains or losses. A capital gain will be taxed differently than your ordinary income rate.
If you spend less than you make, maybe you have saved up an accumulation of cash. Maybe you didn’t find many good options for the money from an investment perspective. Possibly you wanted to keep it liquid and accessible. Money saved is usually the money you have already paid taxes on. In this instance, there are really no tax ramifications if it’s in an after-tax account, like a checking or savings account.
Tying it all together
We need to tie all these pieces together to coordinate and help you determine how will I pay in taxes in retirement. If you need $80,000 in income that is coming from Social Security, pension, and 401K withdrawals, you will need to take out $90,000 to $95,000 to get to the net of $80,000.
Here is a real example of a client. He recently retired a little earlier than 65, around 60, and needed about $80,000 in income.
His income options included:
- Savings
- 401K
- Company stock he had invested over the years
- After-tax mutual funds
- Company pension
- Social Security
With a few different options to choose from, the beauty of retirement income is being able to decide when and how to take the income to try and minimize the tax impact. His original idea was, “Hey, I’m retiring, so I’m going to use my retirement account to live off my 401K.”
Sounds good, right? However, whenever you take money from your 401K, if it’s a traditional 401K, it will be taxed at ordinary income rates. For this client, if he was taking out $80,000 for income, the tax owed was between $8,000 and $9,000. To net the $80,000 he needed required him to withdraw more like $90,000.
Looking over his income sources, we noticed that he had some after-tax mutual funds that had some gains. He wanted to know how much will I pay in taxes in retirement so to try and minimize the tax ramifications of the original plan, we decided to structure him to take $80,000 from his after-tax account. I mentioned earlier that capital gains are taxed at a different rate. However, there’s a capital gain limit. Under a certain amount of income, you pay 0% taxes on your capital gains. It would be great if everyone could pay 0% in taxes but that will not always be the case.
Knowing all of this going in, we planned appropriately. Rather than the original idea, which would cost roughly $9,000 in taxes, he would end up paying zero in taxes, so it’s almost a $9,000 savings. In addition, when your income is structured a certain way, you potentially qualify for subsidies in health care.
This gives you one example of how to thoughtfully create retirement income and an idea of how much income tax you will pay in retirement. Remember, it will vary widely based on your income sources and how you structure that income. The great thing with retirement is that not only do you have freedom with your time, but you also have freedom with how you take income which can be used to your advantage.
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