If you are like most people, you pay careful attention to how you can pay less in federal income taxes while putting money aside for retirement. However, not everyone puts as much thought into how much of their income would be taxable after they retire. To avoid tax bill shock at retirement, you need to plan in advance for how much tax liability you can comfortably handle during your retirement.
Social Security Retirement Benefits
If you worked a job or earned net profits from self-employment, you are entitled to receive Social Security benefits after you retire. Depending on your filing status and income, between 50 and 85 percent of the benefits you receive each year are taxable if you exceed the income limit, notes TurboTax. If you are married and you and your spouse file a joint return, you will have to pay taxes if the total of one-half of your annual income from Social Security benefits combined when added to income from other sources is more than $32,000.
If you didn’t deduct any of your contributions to a traditional IRA account from your income before you retired, your withdrawals are not taxable. However, if you elected to deduct all or part of your contributions from your income in previous tax years, you will owe taxes on the distributions you receive from the account at retirement up to the amount you deducted. The limit on how much of a tax deduction you can claim each year depends on your modified adjusted gross income and filing status. Whether you are ineligible to deduct your IRA contributions or choose not to deduct them, they are considered nondeductible after-tax contributions, according to IRS guidelines. You can limit your tax liability on taxable distributions by limiting the retirement withdrawals you make from pre-tax IRAs and investment accounts.
If you contribute to a Roth IRA account, you don’t have the option of deducting your contributions from your income. Because you make contributions with after-tax dollars, the money you put into the account has already been taxed. Consequently, the withdrawals you make from a Roth IRA during retirement are tax-free as long as you are at least age 59½. Otherwise, it will cost you a 10 percent early withdrawal penalty.
Withdrawals you make from a 401(k) or other pre-tax pension plans may be taxable depending on the income tax bracket you fall into. While plan administrators generally deduct 10 percent from 401(k) distributions for taxes, if you have more than one source of retirement income, you could still owe money when you file your tax return. The IRS bases your tax rate on the total of all of your taxable income for the year. Your tax bill won’t be as steep if you limit the amount of distributions you receive from a 401(k) plan, although each year you will have to withdraw at least the required minimum amount. If you don't, you could lose some big bucks to penalties, cautions Kiplinger.
Managing the Tax Burden
If income from other sources will put you over the annual income limits so that you have to pay taxes on some of your Social Security retirement benefits, you can request the Social Security Administration to withhold federal taxes from the benefit payments you receive each month. You can also contact your account custodians to ask for income taxes to be withheld from taxable IRA distributions and annuities. Another option is for you to make estimated quarterly tax payments to cover your tax liability.
Amber Keefer has more than 25 years of experience working in the fields of human services and health care administration. Writing professionally since 1997, she has written articles covering business and finance, health, fitness, parenting and senior living issues for both print and online publications. Keefer holds a B.A. from Bloomsburg University of Pennsylvania and an M.B.A. in health care management from Baker College.