Types of Taxes Paid By Retirees
One of the most complicated aspects of personal finances is managing taxes. Many of our clients hire us primarily for help in minimizing their tax burden over retirement, preferring to delegate this complex task. Through years of experience, I've learned that even discussing taxes with clients can be challenging. While most people primarily think of Federal Income Taxes, there are actually multiple types of taxes one might pay in retirement. It's crucial to have a general understanding of each type of tax and who benefits from them. In this primer, I'll outline the different types of taxes you might encounter during your retirement years:
Federal Income Taxes
Federal Income Taxes are the most familiar type of taxes for most of our clients and often the primary focus when discussing tax minimization in retirement. As a U.S. citizen, you're required to pay these taxes to the federal government, typically due by April 15th each year. The IRS calculates your federal income tax based on your total taxable income and filing status (e.g., Married Filing Jointly, Individual, Trust). This process involves applying tax rates to different income brackets, accounting for deductions and credits, and considering any taxes already paid through withholding or estimated payments.
As a financial planner, I've found it crucial to begin the planning process by reviewing a client's actual tax return. This approach helps avoid assumptions and provides a clear picture of their tax situation. It's not uncommon for clients to underestimate the complexity of their taxes – I've seen cases where a client claims to have simple taxes but presents a hundred-page return, and others where a straightforward 1040 Senior Tax Return causes them to lose sleep at night.
In retirement, the most common sources of income subject to ordinary Federal Income tax include:
Traditional IRA and 401(k) Withdrawals
Pensions
Social Security Benefits
While most retirees understand they will be paying taxes on withdrawals from Pre-Tax investment accounts, many clients are surprised to learn that they may owe federal income tax on their Social Security benefits. Despite paying 6.2% in Social Security taxes throughout their working years, retirees often find themselves paying federal taxes on these benefits in retirement. In fact, for many of our clients, up to 85% of their Social Security benefits are subject to Federal Income tax, meaning only 15% is tax-free of federal taxation.
State Income Taxes
In addition to federal taxes, many U.S. citizens must pay state income taxes. These funds are typically used for:
State-level education funding
State highways and transportation
State-run healthcare programs
State parks and environmental programs
However, not all states impose income tax. For example, Tennessee, where I live and work, doesn't have a traditional state income tax. This makes it an attractive location for retirees, particularly those moving from high-tax states like California. The potential for an improved lifestyle in East Tennessee, partly due to lower taxes, can be a significant incentive.
One financial planning point:
When discussing retirement planning with clients, it's important to consider the interplay between taxes and other retirement costs. For instance, higher-income retirees may face increased Medicare costs due to the Income Related Monthly Adjustment Amount (IRMAA). While no one enjoys paying higher premiums, it's worth noting that these additional costs (especially in Tennessee!) may still be less than the state income taxes paid in other states.
This becomes particularly relevant when considering financial strategies like Roth conversions. While such conversions might temporarily increase income and trigger higher IRMAA charges, the long-term benefits could outweigh these short-term costs, especially in a state without income tax.
State Sales Tax
Another important tax to consider is the state sales tax, also known as a consumption tax. This tax can significantly impact retirees' budgets, especially in states without income tax. For instance, Tennessee, which doesn't have a state income tax, imposes a higher-than-average sales tax of 9.25%. This effectively increases the cost of most purchases by about 10%, with the revenue going towards funding state programs.
It's crucial to understand that states typically use a combination of income tax and sales tax to generate the revenue needed for their programs. When evaluating potential retirement locations, it's essential to consider the total tax structure of each state. This comprehensive approach will give you a more accurate picture of your potential tax burden and help you make a more informed decision about where to spend your retirement years.
Property Tax
Even with a paid-off home in retirement, property tax bills continue to be a significant expense. As a homeowner in Knox County, Tennessee, I personally experience this by mailing a check for property taxes each December. For many, these taxes are built into monthly mortgage payments, which is often more convenient. Regardless of the payment method, property taxes represent a substantial line item in the average retiree's budget.
Property taxes can easily amount to hundreds of dollars per month, paid to your local county. These funds are crucial for financing local schools and services (trash, etc.). It's important for retirees to factor this ongoing expense into their long-term financial planning, as it doesn't disappear once a mortgage is paid off.
Capital Gains Taxes
Capital gains taxes are a key consideration for retirees with investments. These taxes apply to profits from selling assets like stocks, bonds, or real estate, and are reported on both federal and state tax returns. The good news? Capital gains often receive preferential tax treatment, especially for long-term holdings (longer than 365 days).
Let's break it down with an example:
Imagine you bought 100 shares of XYZ Corp for $15,000 in 2020 and sold them for $40,000 in 2024. Your capital gain is $25,000. Since you held the shares for over a year, it's a long-term capital gain. The tax rate on this gain would be either 0%, 15%, or 20%, depending on your total taxable income. This rate is typically lower than your ordinary income tax rate, which could be as high as 37% for high income retirees.
Managing capital gains is crucial in retirement, particularly if you have substantial non-IRA investment accounts. Some strategies to consider:
Timing your sales to spread gains across tax years
Offsetting gains with losses (tax-loss harvesting)
Using capital gains for charitable giving
Remember, your approach should align with your income needs, investment goals, and overall tax situation. It's worth consulting with a financial advisor to craft a strategy tailored to your unique circumstances. With smart planning, you can make capital gains work for you in retirement.
Estate and Inheritance Taxes
Estate taxes, levied on the transfer of assets from a deceased person to their heirs, currently have a high federal exemption of $13.61 million per individual as of 2024. This is significantly higher than the pre-2017 level of around $5.49 million, thanks to the Tax Cuts and Jobs Act. The tax is paid by the estate before asset distribution, and while it affects few people at the federal level, some states impose additional estate taxes with lower exemption thresholds.
Inheritance taxes, on the other hand, are paid by beneficiaries who inherit assets. While there is no federal inheritance tax, some states do impose them, with tax rates often varying based on the beneficiary's relationship to the deceased. These taxes can be a significant consideration for heirs, especially in states where they are implemented.
From a financial planning perspective, while current federal exemptions limit the impact of estate taxes on most individuals, retirees with substantial assets should remain vigilant. The increased federal exemptions are set to expire after 2025, potentially affecting estates in the $5 to $10 million range. Given the complexity and potential for legislative changes, consulting with a qualified financial advisor or estate planning attorney is crucial for those with significant assets to ensure effective long-term financial planning in retirement. Incorporation of trust strategies, filing the proper tax forms at the passing of a spouse to retain unused credit limits, to name a few can be important.
I would emphasize if your assets are in these levels, having a team of professionals - including a financial planner, attorney, and tax preparer can be essential. These experts can help you navigate the dynamic nature of changing tax laws, ensuring that your estate is managed efficiently and that you're always prepared for potential shifts in legislation. The cost of assembling such a team may be outweighed by the potential savings and peace of mind they can provide in managing complex estate and tax situations.
Payroll Taxes
Payroll taxes are a significant but often overlooked aspect of employment taxation. Many of us can recall the surprise of our first paycheck, realizing that a portion of our earnings was deducted for Social Security and Medicare.
For employees, Social Security tax accounts for 6.2% of their paycheck, while Medicare takes an additional 1.45%. Self-employed individuals bear a heavier burden, paying 12.4% for Social Security and 2.9% for Medicare, effectively covering both the employee and employer portions.
It's important to note that these taxes are mandatory for all earned income, regardless of age or retirement status. Even retirees who have begun collecting Social Security benefits must continue to pay these taxes on any employment income they receive.
Conclusion
I think we better stop here! As you can see, taxes in retirement are no joke - they're complicated and seem to pop up everywhere. For those of you aiming to keep up that $100,000 lifestyle in retirement, it's crucial to take a good, hard look at how taxes will look pre and post retirement.
How you generate that retirement income can make a big difference:
Your marital status
Where you plan to live in retirement
How you will be generating income from your investments
Bottom line: retirement taxes are complicated, but understanding them is half the battle. So, put on your thinking cap and start crunching those numbers - your future self will thank you!
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Remember, while this article provides general information, tax laws can vary by state and change over time. The strategies mentioned may not be suitable for everyone. For personalized advice tailored to your specific situation, it's always best to consult with a qualified tax professional or financial advisor.