How to Estimate Taxes in Retirement

You have made it to retirement—congratulations! There are many exciting things about retirement, but unfortunately, taxes are not one of them. However, taxes in retirement do not have to be intimidating once you understand the makeup of your income sources and how each impacts your tax bill.

Let us look at some retirement income sources and how they are treated on your tax return.

Income Sources

  • Social Security benefits: Anywhere from 0% to 85% of your Social Security benefits can be considered taxable income depending on other income sources. The higher your other income, the more likely most of your benefits will be included in your taxable income.
  • Pensions: Typically, pension income is fully taxable on your federal tax return. Depending on the state you live in and the source of the pension, there may be some exclusions for state taxes, but these vary widely.
  • IRA and employer plan withdrawals: If your IRA and employer retirement accounts [such as 401(k), 403(b), and 457 plans] are funded with pre-tax dollars, distributions from those accounts will be fully taxable.
  • Roth IRA and 401(k) withdrawals: Monies withdrawn from Roth IRAs or Roth portions of employer-retirement accounts are tax-free once you are age 59 ½.
  • Investment income: You may have investments that are not in retirement accounts. These could include stocks, bonds, and mutual funds that you invested in after-tax. Rather than having any tax deferral, you pay taxes on any investment income each year, in the year it is earned. This can include interest, dividends, and capital gains. Because you pay taxes each year (effectively spreading out the tax impact), this is a potential income source that will not cause as large of a tax burden as a tax-deferred account.
  • Annuity distributions: If your annuity is funded with pre-tax dollars (IRA or employer plan), then distributions will be fully taxable. If your annuity is funded with after-tax dollars, it is treated differently. The amount you put in (the “basis”) is non-taxable, but all earnings are taxable as ordinary income. When you begin withdrawals, the earnings are always considered to be withdrawn first. Thus, you must pay taxes on all earnings before you can get to the non-taxable basis of the annuity.

Calculating Your Taxes

Once you have a handle on your sources of income in retirement, the focus shifts to how much you will owe in taxes.

It is important to remember that there are two income figures on your tax return that are used in different ways. Your adjusted gross income (AGI) is the total of all your taxable income sources less some specific above-the-line deductions.

Once you have the adjusted gross income, you deduct either your standard deduction or your itemized deductions.

Here is a chart of the 2021 standard deductions from the Tax Foundation:

Once you have taken the standard deduction (or itemized your tax deductions), the new figure is your taxable income. The taxable income is the figure that is used to calculate your taxes owed.

Below is another chart from the Tax Foundation that shows tax brackets by filing status.

It is important to note that these are marginal tax brackets. If, for example, you are married with $100,000 of taxable income, not all your income is taxed at 22%. It means every new dollar of income is taxed at 22%. The first $19,900 is taxed at 10%, the next $61,150 is taxed at 12%, and only the next $18,950 is taxed at that marginal 22% rate.

Paying Your Taxes

Once you have estimated how much your taxes will be, you need to ensure that those taxes are paid.

You can have taxes withheld directly from your payments for many types of income (including Social Security, pensions, IRAs, and retirement plans). Using this strategy ensures the funds are paid on time, and your year-end tax statement will reflect those payments.

You may also need (or want) to make estimated tax payments. These payments are made quarterly by the taxpayer directly to the federal and state (if applicable) taxing authority.

Even if you do withhold taxes throughout the year, some estimated payments may be required if you have sizable investment income or other sources of income (such as farm or business income).

Planning Your Cash Flow and Taxes

Depending on your resources (assets and cash flow sources), you may have some flexibility on where you draw your income. For example, if most of your income is from Social Security and pensions, you receive set amounts, and these are not flexible.

However, if you have a mixture of pre-tax and Roth retirement accounts as well as investment accounts, you may have flexibility in where you draw funds and thus some control over your taxable income. If that is the case, you may want to look at a withdrawal strategy that maximizes a lower tax bracket but keeps you from moving into a higher one.

Consider working with a fiduciary advisor to look at both your cash flow strategy and tax projections to help you find the combination of income sources that works best for your situation.

Our full-time fiduciary financial planning firm in Topeka and Lawrence, Kansas, helps clients optimize their tax situation as part of their comprehensive retirement plan.

 

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Barbara Duncan, CFP®

As Partner and Senior Wealth Advisor, Barbara Duncan's favorite moments come when a client reaches a long-sought milestone and shares their appreciation for her help in reaching it.