A lot of planning goes into a successful retirement strategy. In addition to saving enough to fund your retirement, you’ll have to consider things like medical and long-term care planning, where you want to live, how much you’ll get in Social Security, what Medicare will cover for you and who the heirs of your estate will ultimately be.
One factor that can sometimes get overlooked is how taxes will affect your retirement. Here are some of the common tax pitfalls that often trip up retirees, and what you can do to avoid them while you’re still planning.
Your Retirement Plan Withdrawals Are Likely Taxable
If you’ve been a diligent saver and investor for your whole life and have hit that mythical $1 million figure in your retirement accounts, congratulations! Depending on your lifestyle, that may be more than enough to fund a happy retirement. But before you revel too much in your millionaire status, remember that most retirement plan withdrawals are likely to be taxable. For example, if you have all of your retirement savings in 401(k) plans or IRAs, all of the money you withdraw from those accounts will likely be taxable, with the rare exception of if you contributed any after-tax money to your accounts.
You’ll Likely Be Forced To Take Taxable Retirement Plan Distributions
If you want to avoid taxes on your retirement accounts by avoiding distributions, think again. With the exception of Roth IRAs — from which most withdrawals are tax-free — the IRS requires you to begin taking mandatory distributions once you reach age 72 unless you turned 70 ½ before Jan. 1, 2020. Even if you don’t want or need the income — or the tax liability — you’ll still be required by law to take them. Failure to do so can result in a whopping 50% penalty of the amount you were supposed to withdraw.
If You Have a Pension, Expect To Pay Tax on That as Well
Pensions aren’t as common as they used to be, as they have been mostly replaced by so-called defined contribution plans like 401(k) plans. However, there are still employers that maintain pensions, and they’re quite typical for government-related jobs. But if you were hoping to avoid taxes on your retirement distributions by having a pension instead of a 401(k) or IRA, you’re out of luck. Pension distributions are treated as taxable by the IRS, just as with other common retirement plans.
Your Social Security May Be Taxed
For some retirees, Social Security benefits are not taxed. However, if you have outside income and exceed the Social Security Administration’s thresholds, either 50% or 85% of your Social Security income will be taxable. The combined income thresholds for individual and married taxpayers are as follows:
- For individuals, up to 50% of benefits are taxed on a “combined income” between $25,000 and $34,000.
- Up to 85% of benefits are taxed for individuals with combined income of more than $34,000.
- For married filers, a combined income of $32,000 to $44,000 triggers tax on up to 50% of Social Security benefits.
- Up to 85% of benefits are taxed for married filers with a combined income of more than $44,000.
For purposes of this calculation, “combined income” is considered to be your adjusted gross income plus your nontaxable interest and half of your Social Security benefits.
Your Property Tax Will Likely Go Up
Many retirees live on fixed incomes and plan on having relatively static expenses. Although most costs tend to rise slowly over time due to the effects of inflation, some of these can be offset with annual cost-of-living adjustments from Social Security payouts or investment returns. Retirees can also trim expenses by purchasing less-expensive items or generic brand names. But if you own your home, one expense you’ll have little control over is rising property taxes. For those already retired, the skyrocketing home prices over the past few years have left some homeowners with large jumps in their assessed values and property taxes. While some will say this is a good problem to have, for a retiree not interested in selling their home, it just amounts to another rising expense that acts as a drain on their cash flow.
The Capital Gains in Your Retirement Accounts Will Be Taxed as Ordinary Income
If you’re an investor, you likely understand that long-term capital gains, or those held for longer than one year, enjoy beneficial tax treatment in the form of lower tax rates. Whereas ordinary income, like wages or interest, is taxed at your marginal tax rate, most long-term capital gains only face a 15-20% tax — or even 0%, depending on your income. But even if all of the gains in your 401(k) or IRA are from long-term holdings, you’ll still have to pay ordinary income tax on your distributions from these types of plans.
Even Your Roth IRA Distributions May Be Taxable
One of the best ways to avoid taxes on your retirement accounts is to use a Roth IRA. Contributions to a Roth IRA are made after tax, but distributions are typically tax-free. However, this is not always the case. If you take a distribution from a Roth IRA less than five years after you open it, your earnings are still taxable, even if you are over age 59 1/2. If you’re under age 59 1/2, you’ll also face premature withdrawal penalties. Your contributions to your Roth, however, are always available for tax-free withdrawal.
If You’re Part of the FIRE Movement, You Might Face Taxes and Penalties on Your Retirement Plan Withdrawals
The financial independence, retire early movement, also known as FIRE, has been growing in popularity among younger investors looking for a nontraditional retirement. And while there are certainly many advantages to retiring in your 30s or 40s, you may be setting yourself up for some problems when it comes to your retirement accounts. Distributions from traditional IRAs and 401(k) plans are not only fully taxable, but they also carry 10% early withdrawal penalties for money you take out before age 59 1/2. While there are exceptions, if you’re planning on this type of money to fund your early retirement, you’ll have to factor in the additional taxes and penalties.
You Might Face Estate Taxes
If you die with a sizable estate, you won’t have to deal with estate taxes, but your heirs might. If your estate is larger than $12.06 million for tax year 2022 — or $24.12 million for couples — your estate will have to file a tax return and may face taxes on amounts above these limits. The estate tax rate starts at a relatively modest 18% but rapidly jumps to 40% for estates with as little as $1 million above the exemption amount. Careful tax and estate planning can help minimize the sting of the estate tax on your heirs, but you’ll likely need to work with a tax specialist and/or estate planning attorney to properly protect your assets.
Gifting May Also Result in Taxes
If you’re looking to avoid estate taxes, making gifts while you’re still alive is a way you may be able to reduce your taxable estate. For the tax year 2022, the IRS allows individuals to gift up to $16,000 per year to anyone they choose — this can be multiple people all receiving up to $16,000 — without having to file a gift tax return or pay taxes, up from $15,000 in 2021. This amount is doubled for joint filers. The IRS also grants a lifetime exclusion of up to $12.06 million for individuals, or $24.12 million for couples. However, amounts above that face gift tax rates, and any amounts applied to the lifetime exclusion reduce your estate tax exemption at death by the same amount. Again, these numbers apply to a very limited number of Americans, but they’re important to note if you’re retiring with a large estate.
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