Dialing in taxes during retirement is a little like working with a Rubic's cube!
Managing personal income taxes in retirement is very different from the days when you just receive a paycheck, net of taxes, and know that there are calculations going on behind the scenes making sure you pay your due. If you are a small business owner, this may not be as much of an adjustment since you are more accustomed to filing quarterly. For me it was an awakening, and it continues to be a source of curiosity and challenge all rolled into one.
What is Different
My husband and I had corporate jobs throughout our accumulation years. Taxes were withheld, contributions were made to the appropriate retirement accounts, deductions for mortgage interest, taxes, charitable contributions, etc. were tallied up at year-end and we (mostly) paid the difference or occasionally received a refund. Done.
In this brave new world of retirement, there are estimated quarterly taxes to be paid, balancing retirement account withdrawals with withdrawals from taxable accounts, income thresholds for Medicare and potential taxes on social security depending on other income sources, not to mention the potential Roth Conversions, inherited IRAs, and the world of small business taxes.
In our new life, as semi-retired sole proprietors, we pay estimated quarterly taxes. I missed a few(!) but am now receiving proper guidance from my advisors, thank goodness. This was one of those situations where everyone assumed I knew what I was doing. Not so much.
Many retirees need to pay estimated quarterly taxes. The government’s perspective on taxes is pay as you go! How much depends on your estimated yearly income, which during this beginning stage of retirement, can swing wildly for assorted reasons.
During the beginning of retirement many things are new and unknown. Your lifestyle may not be dialed in, and you may have uncertainty about working part-time. You may decide to see how it goes before making any big or irrevocable decisions like taking Social Security too early.
Perhaps you feel uncomfortable tapping retirement accounts. Sometimes people forget that withdrawals after 59 are penalty free and others believe they must wait until age 72.
It may be that you are unsure about the best way to create a tax-efficient paycheck from your assets.
Uncertainty is normal. This is a new chapter. Most of us feel better proceeding with caution, knowing that it will be difficult to recoup financial mistakes. In our case, our income in the first two years came from savings, business income, and small IRA withdrawals. Our ultimate goal was to get to a place where we generated a consistent retirement “paycheck”. This required working with our financial planner/investment manager and accountant. Your financial advisor and CPA are your best sources for guidance. Turbo tax provides helpful information in this article.
Why is calculating taxes different in retirement?
Generating a paycheck in retirement comes from a variety of sources and each may be taxed at a different rate. There may be multiple sources of income in retirement. Below is a list of very common sources
A quick caveat: we are not offering tax advice, rather an abbreviated version of how taxes are generally accrued and taxed. For specific advice for your situation, we encourage you to seek professional advice from your accountant
Investment Income: Capital Gains, Dividends and Interest
Withdrawals from taxable accounts are not subject to income tax. What is taxable for these accounts are capital gains, interest, and dividends. Capital gains tax can vary from 0%, 15% and 20%, depending on your income and filing status.
Non-municipal interest is taxed at your ordinary income tax rate. Qualified dividends are taxed at 0%, 15% or 20% depending on your income and filing status. Ordinary dividends are taxed at ordinary income rates. This is the same whether you are working or retired. However, if you need to make quarterly tax payments you would need to factor this into your estimated quarterly tax payment.
Withdrawals from Retirement Accounts
Many retirement accounts grow tax-free and contributions are made before taxes are withheld. In this case, withdrawals are subject to ordinary income tax. Exceptions include Roth IRAs as well as tax-paid contributions to retirement accounts. It is currently mandatory to take withdrawals from traditional IRAs and retirement accounts starting at age 72. There is no minimum withdrawal age for Roth IRAs.
It is possible to not pay income tax on your withdrawals if you have significant itemized deductions or if you are making a direct charitable contribution (QCD). QCD’s have strict rules. For instance, you can only make these contributions if you are 70 ½, and it must be less than $100,000 and to a qualified charity. The good news is the QCD counts as the RMD for that year.
Pension income is generally taxed at ordinary income tax rates.
Owing taxes depends on whether the annuity is purchased with pretax or post tax income.
Whether or not social security is taxed depends on how much retirement income you have and how it is generated.
Other Sources of Income
As we indicated above income can also come from employment (W-2), working as a “contract employee (1099), rental income, divorce proceeds, etc. It is important to understand the tax implications of each so that quarterly estimates are accurate and filed on time. Working with an accountant is important, especially since our tax code is becoming more complex.
Planning your tax strategy
We recommend an annual fourth-quarter meeting with your accountant and financial advisor to finalize your year-end tax situation and plan for the following year. This provides an opportunity to fine-tune the current year’s numbers with an eye to the future. Mosaic Fi uses a tax planning and projection tool that can help you consider tax planning opportunities like ROTH conversions, tax-efficient withdrawals, charitable giving, and much more.
Of course, if you have questions, please contact Jenifer at 773-425-6790.