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Managing Taxes in Retirement

When you disengage from the traditional working world, the process of calculating your tax obligations could become more complicated

By Charles Schwab & Co.

During your working years, your employer typically withholds income tax on your behalf, helping to avoid underpayment penalties come Tax Day. But when you get to retirement, you generally have multiple income sources that may or may not have the appropriate taxes withheld, leaving you to pay estimated taxes throughout the year.

A retired man doing his taxes. Next Avenue
Generally speaking, retirees' taxable income sources will fall under one of two federal tax categories: ordinary income and long-term capital gains.  |  Credit: Getty

"If you don't make adequate estimated tax payments, you could face a big tax bill and potential penalties when you file your taxes," says Hayden Adams, director of tax and wealth management at the Schwab Center for Financial Research. Both a Certified Public Accountant and Certified Financial Planner, he spent eight years as a senior auditor for the IRS before joining Schwab.

Four Fundamental Questions

Here are four questions to help new and soon-to-be retirees determine their federal tax obligations — and how to satisfy them going forward.

1. What Are Your Sources of Retirement Income?

Generally speaking, retirees' taxable income sources will fall under one of two federal tax categories:

Ordinary income, which is taxed from 10% to 37% and includes:

  • Wages paid by an employer.
  • Interest payments (excluding those from tax-free municipal bonds).
  • Ordinary dividends.
  • Short-term capital gains (on assets held a year or less).
  • Taxable withdrawals from retirement accounts. This excludes withdrawals from Roth accounts, which are tax-free if you're 59½ or older and the account has been open for at least five years.
  • Taxable Social Security benefits.
  • Health Savings Account withdrawals for nonqualified expenses. Before you turn 65, your nonqualified withdrawals may incur a 20% penalty. At age 65, all withdrawals are penalty-free.
  • Annuity payouts, depending on whether the annuity was bought with pretax or after-tax funds.
  • Rental income.
  • Pension payouts.

Long-term capital gains, which are taxed at 0%, 15% or 20%, depending on your total taxable income. Capital gains generally include profits from the sale of a business, real estate, securities and most other assets held longer than a year, as well as qualified dividends. You may avoid tax on $250,000 in gains ($500,000 if married) on your primary residence if you lived in the property for at least two of the past five years.

"It's not uncommon for today's retirees to have five or more sources of income."

What's more, if your modified adjusted gross income is $200,000 or more as a single filer or $250,000 or more as a married couple filing jointly, you'll face an additional 3.8% net investment income tax (NIIT) on income generated from investment assets, which generally include interest, dividends, long- and short-term capital gains, rental and royalty income and nonqualified annuities.

"It's not uncommon for today's retirees to have five or more sources of income," Hayden says. "However, the more sources you have, the more challenging it can be to figure out exactly what you'll owe and how much to withhold."

2. How Much Are You Withholding?

To complicate matters, taxes are automatically withheld from some income sources but not from others — and the amounts withheld may not satisfy your actual tax liability. For example:

  • 401(k), 403(b) and other qualified workplace retirement plans: Generally, most withdrawals are subject to 20% withholding. However, withdrawals made to satisfy your annual required minimum distributions (RMDs) are subject to 10% withholding, which for high-income retirees may be far too low. For example, a single 73-year-old retiree with a $2.5 million IRA would face an RMD of $94,340 this year, placing them squarely in the 22% tax bracket even before accounting for other income.
  • Annuities and pensions: Taxable, periodic (that is, regular) payments from annuities and pensions are treated as ordinary income and taxes are withheld according to the withholding tables in IRS Publication 15-T.
  • Social Security: Depending on your combined income — which includes your adjusted gross income, tax-exempt interest income and half of your Social Security benefits — up to 85% of your total Social Security benefits could be taxable. However, the Social Security Administration (SSA) won't withhold taxes unless you submit a request for it to do so. Withholding rates are fixed: 7%, 10%, 12% or 22%.
  • Taxable bank or brokerage accounts: In most instances, taxes are not withheld from realized capital gains, dividends, or other income generated from such accounts. "If you'll draw a significant portion of your income from these sources, you'll need to either have more taxes withheld from other income sources or pay quarterly estimated taxes," Hayden says (see "What's your payment plan?").
  • Traditional, SEP and SIMPLE IRAs: Unless you specify otherwise, your plan's custodian will withhold just 10% of your taxable distributions.

3. What Do You Owe?

If you're newly retired, figuring out your tax bill for the first time can feel intimidating, especially because there's no IRS calculator or tool to ensure success.

"It's wise to enlist the help of a professional, especially in the first few years of retirement."

That said, several online resources exist to help estimate your taxes. AARP, for example, has a robust tax calculator that uses your income, filing status, deductions and credits to gauge your total taxes for the year. Likewise, most of the major tax preparation companies also offer free online tools to help you estimate your tax bill.

"These resources can be a great jumping off point," Hayden says, "but it's wise to enlist the help of a professional, especially in the first few years of retirement. Not only can they help you calculate your tax liability, but they can also suggest ways to minimize it now and in the future."

4. What’s Your Payment Plan?

Once you know how much you'll likely owe in taxes for the year, you'll next need to determine how to pay it. Generally speaking, you have two options:

Adjust your withholding. This is perhaps the easiest approach. "Once you've established the necessary withholding amounts from the accounts that allow for it, it's pretty much set it and forget it until the next tax year," Hayden says. For example, if your estimated total tax liability is $30,000 and you plan to withdraw $100,000 from your 401(k) over the course of the year, you could simply withhold 30% of each 401(k) distribution. "Paying all your taxes from a single income source can make it easier to track, as well as offset any sources of income that don't withhold the necessary taxes," Hayden says. "Just be sure to update your other withholding amounts to 0% so you don't end up giving the IRS too much."

"If you don't make adequate estimated tax payments, you could face a big tax bill and potential penalties."

Make quarterly estimated payments. You may have to make quarterly estimated payments if you realize unexpected income, have significant rental or taxable investment income, or are self-employed. If you don't make estimated payments to satisfy your extra tax liability, you could face an underpayment penalty. "As with calculating your overall tax liability, calculating your estimated payments can take some work, so it could make sense to enlist the aid of a tax professional," Hayden says.

The Very Good News

Once you've made it through your first year of retirement, the IRS offers a shortcut for future years: You can avoid penalties and having to recalculate your tax liability each year simply by withholding 100% of last year's taxes if your adjusted gross income (AGI) is $150,000 or less, or 110% of last year's taxes if your AGI is more than $150,000 ($75,000 for individuals or married couples filing separately).

"For those who expect their income to be similar to the previous tax year, it's a great way to avoid the hassle of calculating it all again from scratch," Hayden says. "It won't be perfect — you might still owe a bit of tax or be due a refund — but the goal here isn't perfection, it's simplicity. After all, who wants to spend more time than absolutely necessary worrying about taxes?"

Editor’s note: This article originally appeared on Charles Schwab & Co.'s website.

Charles Schwab & Co.amp; Co. manages $7 trillion in client assets, including defined contribution retirement savings, retail wealth management and brokerage accounts and bank deposits. Read More
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