When we are working, taxes are a part of daily life and influence the considerations that we take in our spending habits. Once we start thinking about retiring, we often forget to add in taxes as a component to our thought process. It is important to understand your tax situation in retirement prior to retiring so that you will be ready when the time comes to pay on the taxes due.
1. Social Security
When we think about retirement, Social Security tends to be the first thing that comes to most people’s minds. An individual’s Social Security is funded by reducing a portion of their paychecks as taxation payable towards the Federal Insurance Contributions Act, better known as FICA taxes, as well as their employer paying in matching taxes from their own funds. For the self-employed, both sides of FICA are paid through self-employment taxes based upon the Self-Employment Contributions Act of 1954 (SECA) by the self-employed individual. Social Security was originally created through the Social Security Act of 1935, to ensure basic rights to each person as they aged, became unemployed, and for under working age children. While it has gone through several changes since President Roosevelt first signed it into law, the idea behind Social Security remains the same.
Up until 1984, Social Security benefits remained untaxable. This was different than private pensions, in that most private pensions are partially taxable. Private pension benefits are taxable to the extent the pension recipient is generally liable for the portion of the benefits that (s)he did not her/himself contribute. This includes the employer portion of the pension contributions, as well as interested earned by the funds. The 1983 Amendments to the Social Security Act, challenged the taxability of Social Security benefits by determining that Social Security was also not funded solely by the individual employee. Additionally, many individuals were receiving benefits over and above the amount that they themselves contributed due to Social Security’s program operating on the insurance principle. In the 1983 Amendments, Congress approved that Social Security up to fifty-percent of the value of the benefit could be potentially taxable. In 1993, as part of the Omnibus Budget Reconciliation Act, a secondary threshold was created that meant that up to eighty-five percent of Social Security benefits could be potentially taxable. The intention here was to bring Social Security closer in line with private pensions, but only for the higher-income beneficiaries.
Knowing the income thresholds that will push your Social Security into a taxable position, will be important as you approach retirement. The higher your income, the larger the percentage of Social Security benefits you will have to pay taxes on. The income used in the threshold calculation is known as your adjusted gross income and include pensions distributions, retirement account withdrawals from taxable retirement (other than Social Security), and tax-free interest; as well as any earned income you may have. This makes Roth accounts a good option for retirement planning,
2. Traditional and Tax-deferred Accounts Versus Roth Accounts
There are may ways of thinking and planning for retirement account funding, much of which will depend on where you are in your working life, as well as retirement goals and needs. As this is a brief overview of the three general types of retirement accounts, discussions on which plan type is right for you should be reviewed with your retirement plan broker and tax accountant.
Traditional individual retirement accounts (IRA) are funded by contributions made with after-tax dollars that allow for tax-free growth. The contributions made to these accounts are potentially deductible on your income tax return. These are generally utilized to supplement employer-sponsored plans that may not accumulate enough to give you the retirement savings you need.
While you are working, tax-deferred retirement accounts provide the benefit of reducing your taxable income while you save for the future. Contributions to these types of retirement plans allow you to contribute directly from your wages or self-employed income before taxes. However, once you have retired, any distribution from these funds becomes taxable. The idea is that at the point you begin to withdraw these retirement funds, you will be in a lower tax bracket than when you were working. At age seventy and a half, the Internal Revenue Service requires you to take a certain amount of funds out of your account each year. The penalty for not taking your required minimum distribution is fifty percent of the amount you should have withdrawn.
On the flip-side, distributions that you take out of your Roth retirement accounts are tax-free. A Roth is an after-tax contribution funded account. Most other retirement contributions are either made with pre-tax dollars or are deductible against taxable income. Roths are not. So, while you will not see the benefit of a Roth contribution while you are working, qualified withdrawals from the account in retirement are tax-free (as long as the account has been open for five years or more). Roths also lack the required minimum distribution portion that non-Roth accounts have. Roths also allow you to withdraw the contribution amount at any time and for any reason, without penalty.
3. Withholding and Estimated Tax Payments
When we are working for an employer, most of our annual tax liability gets paid in the form of federal withholding on our paychecks. Withholding is calculated using the IRS tables and based on the information on your Form W4. While many of us would prefer to have those extra dollars in our pockets each month, it does reduce or can potentially wipeout the taxes due in April. In this way, paying a little in each pay period can be beneficial to a large tax hit in April. Once we retire, however, these payments are no longer made through our wages. With the IRS requirement that says that you must make payments throughout the year if you are going to owe one-thousand dollars or more, knowing your potential tax ahead of time is crucial. You must ensure that you pay at least what you owed in the prior year, or one-hundred and ten percent if your adjusted gross income will be more than one-hundred-fifty-thousand dollars. This will reduce the underpayment penalty but may not cover the taxes you end up owing in the current year. One way to achieve this pre-payment is to continue your withholding through your retirement payments. Another is to make estimated tax payments throughout the year in quarterly installments. These can be made through the IRS website or via check with a voucher you will receive with your annual tax return if requested. The calculation of what you may owe can be complex and it is best to seek the advice of a tax professional.