When most people think about retirement planning, they tend to focus on one big question:
“Will I have enough money to retire?”
But there’s another question that can be just as important:
“How much of my retirement income will I actually get to keep?”
Your retirement tax bill can have a significant impact on how much money you have available to spend, travel, cover healthcare costs and enjoy the retirement you’ve worked toward.
Many retirees are surprised to discover that taxes don’t necessarily disappear when they stop working. In fact, depending on where your retirement income comes from, your tax situation could look very different in retirement than it did during your working years.
Understanding your potential retirement tax bill ahead of time can help you make more informed decisions about saving, withdrawing money and creating a retirement income strategy.
Why Do You Still Pay Taxes in Retirement?
Retirement doesn’t automatically mean you’re done paying taxes.
You may no longer receive a paycheck from an employer, but you could still have several sources of income that may be taxable, including:
- Traditional IRA withdrawals
- 401(k) withdrawals
- Pension income
- Taxable investment income
- Required Minimum Distributions (RMDs)
- Certain Social Security benefits
- Other sources of taxable income
The amount of taxes you ultimately pay will depend on your individual circumstances, including your income, deductions, filing status and the types of accounts you own.
That’s why it’s important to look beyond the total amount you’ve saved for retirement and consider how much of those savings may eventually go toward taxes.
Your Retirement Savings May Not All Be Taxed the Same
One of the most important concepts in retirement tax planning is understanding the difference between tax-deferred, tax-free and taxable accounts.
For example, money in a traditional IRA or 401(k) generally hasn’t been taxed yet. When you take withdrawals, those distributions are generally included in taxable income.
Roth accounts work differently. Qualified withdrawals from a Roth IRA can generally be tax-free, provided certain requirements are met.
Taxable investment accounts can have their own tax considerations, including capital gains and dividends.
This means that two retirees with the exact same amount of savings could potentially have very different tax situations depending on where that money is held.
Here’s a simple example:
Imagine two retirees each have $1 million saved for retirement.
One has most of their savings in traditional tax-deferred accounts.
The other has a combination of traditional accounts, Roth accounts and taxable investments.
They may have the same amount saved, but they don’t necessarily have the same after-tax retirement income.
That’s why the question isn’t simply:
“How much have I saved?”
It may also be:
“How much of my retirement savings will I actually get to spend?”
Required Minimum Distributions Can Increase Your Taxable Income
Required Minimum Distributions, commonly called RMDs, are another important consideration when estimating your retirement tax bill.
Once you reach the applicable RMD age, you generally must begin taking required distributions from certain retirement accounts, even if you don’t need the money to cover your living expenses.
Those distributions can increase your taxable income.
For some retirees, that may not create a major issue. For others, large RMDs could push taxable income higher than expected and affect other areas of their financial plan.
This is one reason it can be helpful to think about taxes before you’re required to take distributions.
Depending on your circumstances, there may be strategies worth discussing with your financial and tax professionals, such as managing withdrawals across different account types or considering Roth conversions.
Social Security May Be Part of Your Tax Picture
Another common misconception is that Social Security benefits are always tax-free.
Depending on your overall income and filing situation, a portion of your Social Security benefits may be subject to federal income tax.
This means your retirement tax bill isn’t necessarily determined by your IRA or 401(k) withdrawals alone.
Your Social Security benefits, pension income, investment income and retirement account distributions can all work together to determine your overall tax situation.
That’s why it’s important to look at the big picture rather than evaluating each income source separately.
Your Tax Bracket Could Change in Retirement
You may assume that your tax bill will automatically be lower after you retire because you’re no longer earning a salary.
That may be true for some retirees—but it isn’t guaranteed.
Your taxable income could come from several sources at once:
- Social Security
- Pension income
- IRA withdrawals
- 401(k) withdrawals
- RMDs
- Investment income
- Other taxable income
At the same time, your filing status and available deductions may change throughout retirement.
Your tax situation can also change after the death of a spouse, when a surviving spouse may eventually file as a single taxpayer.
The result is that your retirement tax bill can look very different from what you experienced while working.
Why Retirement Tax Planning Should Start Before Retirement
One of the biggest mistakes you can make is waiting until you’re retired to think about retirement taxes.
While you’re still working, you may have opportunities to make decisions that could affect your future tax liability.
Depending on your circumstances, that could include considering:
- How much you contribute to different types of retirement accounts
- Whether Roth contributions or conversions may make sense
- When to begin taking Social Security
- How and when to withdraw from retirement accounts
- How to manage Required Minimum Distributions
- How to coordinate retirement income sources
- How your tax situation could change over time
Not every strategy is right for every person. The goal isn’t necessarily to pay the least amount of taxes this year.
Instead, retirement tax planning is about looking ahead and understanding how today’s decisions could affect your taxes over the course of retirement.
Don’t Just Plan for Your Retirement Savings—Plan for Your Retirement Tax Bill
When you’re preparing for retirement, it’s easy to focus on the number in your retirement accounts.
But that number doesn’t tell the entire story.
If a significant portion of your retirement savings is held in tax-deferred accounts, you may have a future tax liability that isn’t reflected in your current account balance.
Understanding your potential retirement tax bill can help you make more informed decisions and avoid being caught off guard later.
The important thing is to start with an estimate.
Once you understand your potential tax liability, you can explore whether there are strategies that may help you manage it.
Calculate. Evaluate. Act.
At Buska Retirement Solutions, we’ve created a simple way to help you get started.
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