Did you know that you will most likely continue to pay taxes even during retirement? The tax is calculated based on your yearly income, much like how it was before your retirement. However, understand that different tax rules can apply depending on the type of income you receive.
Knowing how each different type of income shows up in your taxes will help you minimize your taxes during retirement and avoid potential audits. You will also get to estimate the amount of money in taxes that you owe the state or federal government. Below is a detailed look at the six common retirement income types and their rules of taxation.
1. 401(k) And IRA withdrawals
Any withdrawals from the tax-deferred retirement accounts get taxed like any other ordinary withdrawal. What this means is that you get to pay the normal income tax every time you withdraw from the 401(k) and/ORT IRA accounts.
Although considered a long-term investment, tax-deferred retirement accounts are not taxed at long-term capital-gains rates. Note that 457 and 403(b) plans are also treated in the same manner and considered as taxable income.
The amount of tax will come down to your tax bracket and the total amount of deductions and income you have. However, the good news is that you might be exempted from these taxes if you have more deductions than income during a particular year. You can, therefore, rest easy if you have had a lot of medical expenses during the year.
2. Social Security income
For starters, note that you will most likely not pay any retirement taxes if you only get income from your social security benefits. However, a portion of these benefits will usually be taxed when you have different types of income apart from your social security income.
There is a standard formula that determines the exact amount of your taxable social security income. In most instances, you will likely need to include up to 85% of your benefits. The taxable amount will range anywhere between 0-85% depending on the amount of income you get from other sources.
Simply plug your other income (referred to as combined income) into a formula right in the tax worksheet to know the number of benefits that will be taxable.
3. Pension income
Contrary to what you might be thinking, most of the pension income is classified as taxable. Note that the pension income gets taxed if you withdraw any pre-tax amount that you contributed into the fund. Because most of these accounts get funded by pre-tax income, your annual pension income usually gets labeled as taxable income.
However, only a small percentage of your pension income gets taxed each year if you mainly funded your account with after-tax dollars. You must, therefore, carefully analyze whether your pension account was primarily funded with pre-tax or after-tax income.
4. Investment income
You will still have to pay taxes on capital gains and dividends even in retirement. Did you know that investment income is usually reported on the 1099 tax form every year? This form is normally sent directly to you from the financial institution with the funds.
However, do not expect to pay taxes on gains upon the sale of your house. You will only pay tax on these gains if you have lived in the house for less than two years, the gains exceed $500,000 if you are married, or $250,000 if you are single.
The importance of understanding tax rules
Your tax rate after retirement will come down to the total amount of your deductions and taxable income. It is, therefore, vital that you don’t get caught off guard by your tax bill during retirement. Understanding the above tax rules will help you avoid hefty fines and keep you compliant with the law.