Which tax changes do new retirees need to know about?

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How to Slash Your Retirement Tax Bill

When you retire from working, a lot can change in your tax life. Some of the changes will make life easier and cheaper for you in your golden years, while others add a layer of complexity and cost that you may very well not want to deal with in your retirement.

Still, by tackling those changes head-on you can better prepare yourself financially for the inevitability of your new tax situation as a retiree. The sooner you're in control of your retirement tax situation, the more of your time you can spend on the truly important things in life.

The Good

Perhaps the most pleasant tax change awaiting you in retirement is the fact that you stop paying Social Security and Medicare taxes once you stop drawing a paycheck. Indeed, once you're eligible to receive benefits from those programs, you can start getting back a portion of the money you've paid into those systems throughout your working career.

Additionally, your state may offer you some benefits, too. Many states have rules exempting at least some of your Social Security, pension, investment income, or IRA withdrawals from state income taxes -- particularly once you've officially retired. On top of that potential for lower state income tax rates, once you've reached a traditional retirement age, you may be able to get a "homestead exemption" that reduces your property taxes as well.

The Bad

Unfortunately, not every tax change once you stop working is a good one. For one thing, once you no longer draw compensation-style earnings, you stop being eligible to contribute to a qualified tax-deferred retirement plan such as an IRA or 401(k). For much of your working career, any money you funneled into a tax-deductible retirement plan reduced your taxable income (and total tax burden), and the money in those plans compounded tax-deferred, as well.

Not only do you lose the ability to contribute once you start working, but with traditional qualified retirement plans, you start facing required minimum distributions once you reach age 70½. Those mandatory distributions get to be larger portions of your account balance over time. As they get bigger, those distributions could force you to declare income and pay taxes on money you otherwise wouldn't technically need to withdraw or spend.

If that weren't enough, as much as 85 percent of your Social Security benefit itself could be subject to federal income taxes, depending on your filing status and income. At least part of your Social Security is subject to taxes if your "combined income" (half your Social Security benefit plus all your other income -- including tax-exempt interest) is at least:
  • $0 if you're married filing separately and lived with your spouse at all during the year.
  • $25,000 if you're single, head of household, qualifying widow(er), or married filing separately and did not live with your spouse at all during the year.
  • $32,000 if you're married filing jointly.
Just like the taxes you paid on your earned income, taxes on your retirement income have to be paid in a timely manner for you to stay in good graces with the IRS and avoid penalties for underpayment.

The Confusing

Speaking of the need to make timely payments to the IRS: If you had a traditional paycheck, your employer withheld taxes based on your income while you were working. That was to make sure Uncle Sam and your state got their cuts. Once you're retired, the withholding rules get less strict, even though getting your taxes paid on time remains a requirement if you want to avoid a penalty.

To the IRS, a payment is timely if enough is paid through withholding or via sufficient estimated tax payments, paid four times a year, to cover the taxes you owe or place you in a safe harbor for the year. Most 401(k) distributions are subject to mandatory withholdings if they aren't directly rolled over to other qualified plans, and you can have taxes withheld from your pension or annuity payment, Social Security benefit, or IRA distributions as well.

If you choose to go the estimated tax route, then sharpen your pencil and make sure your calculator has batteries -- or that your tax filing software knows of your plans in advance. Estimated taxes need to be paid four times a year, with the first payment due April 15 for money earned from Jan. 1 through March 31. If you tell most tax software packages that you plan to pay estimated taxes, they can pre-fill the forms for you for the upcoming year, based on the "prior year taxes safe harbor rule." Then, you simply need to mail the checks on time.

If you're doing it by hand, the IRS' form and primary worksheet for estimated tax payments is 1040-ES. It's not quite as complicated as running your entire tax bill every quarter, but it can take some effort to do it correctly in order to avoid a penalty for insufficient timely payments.

Going the estimated tax route may be complicated, but one benefit is that if your income doesn't come in evenly throughout the year, you can more easily match your tax payment to when you received that income. For instance, if you have mutual funds that pay you capital gains distributions in December that change from year to year, you can handle that with your 1040-ES by using the "Annualized Income Installment Method."

Be Prepared With Your Taxes and Enjoy Your Retirement More

Once you retire, your primary source of income changes, and the way you get taxed on your income also changes. By understanding those changes, you can find the right balance that keeps money in your pocket throughout the year while still paying enough in a timely manner to keep yourself in Uncle Sam's good graces.

With your taxes under control, you can spend more of your retirement doing the things you enjoy. And isn't that what retirement is really all about?

Chuck Saletta is a Motley Fool contributor. Try any of our Foolish newsletter services free for 30 days. To read about our favorite high-yielding dividend stocks for any investor, check out our free report.
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