5 new taxes to watch out for in retirement
Once you retire, you will probably have less money coming in than you did while you were working. Some people even drop into a lower tax bracket when they retire. There are also a variety of tax breaks specifically for older people. However, several new types of taxes might come up in retirement. Here are some of the taxes retirees might incur.
Required minimum distributions. Annual distributions from traditional 401(k)s and traditional IRAs are required after age 70 1/2. Income tax will be due on each withdrawal. A retiree in the 25 percent tax bracket who withdraws $5,000 from an IRA will owe $1,250 for income tax on the distribution. "Many people will start taking money out of their retirement account in big chunks to get this done with, but that's a mistake that can sometimes throw you into a higher tax bracket," says Jill Schlesinger, a certified financial planner and Senior CFP Board Ambassador.
There are a couple of ways to delay or avoid paying tax on required minimum distributions under very specific circumstances. Savers who work in retirement for a company they don't own may be able to delay required minimum distributions from the 401(k) associated with their current job until they actually retire, if the plan allows it. However, distributions from 401(k) plans from previous employers and traditional IRAs are required regardless of your employment status. Also, people age 70 1/2 or older who directly transfer up to $100,000 from an IRA to a qualified charity can satisfy their distribution requirement without paying any tax on the transaction. "They can actually send it directly from the IRA and it counts toward their RMD, yet it won't be considered in their taxable income," says Steven Podnos, a certified financial planner for Wealth Care in Cocoa Beach, Florida. "That may help them keep inside a lower bracket and pay overall lower taxes."
Distributions from Roth 401(k)s are also required after age 70 1/2, unless you are still working for a company you don't own. However, if you are taking a withdrawal from a Roth account that is at least 5 years old and you are over age 59 1/2, you won't have to pay income tax on the distribution.
Roth IRAs don't have any distribution requirements for the original account owner. Your money can continue to grow tax-free in a Roth IRA for the rest of your life, and you don't have to withdraw the money unless you need it. "As you get older, it's so nice to have this Roth asset that has already been taxed and is not subject to RMDs," Schlesinger says. Distributions from Roth IRAs in retirement are often tax-free.
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Two required minimum distributions in the same year. Taxpayers who turn 70 1/2 during 2017 must take their first required minimum distribution by April 1, 2018. However, all subsequent distributions must be taken by Dec. 31 each year, so the second RMD will be due by Dec. 31, 2018. Taking two distributions in the same year can result in an abnormally high tax bill in a single year. In some cases, taking the distribution during separate calendar years can help to keep your tax bill manageable, but there are also cases when it makes sense to double up. "Let's say in the year you turn 70 1/2 you are still working and in a higher tax bracket. You might not want to take the RMD and tack that on top of your earned income," says Jennifer Failla, a certified financial planner for Strada Wealth Management inAustin, Texas. "If you retire the next year, you can take them both when you don't have another source of income."
Forgetting a 401(k) or IRA withdrawal. There's a 50 percent tax penalty if you fail to take annual distributions from your traditional retirement accounts after age 70 1/2. That tax penalty is applied in addition to the income tax you owe on traditional retirement account distributions. A retiree in the 25 percent tax bracket who skips a $5,000 required IRA withdrawal will owe $3,750 in taxes and penalties. "If you have four different IRA accounts, you can do a calculation based on the total value of those IRAs and take one distribution, but you can't do that with a 401(k)," Schlesinger says. "You have to take a separate distribution from the 401(k)."
You can no longer claim a tax break for IRA contributions. Many working people are able to reduce their taxable income by contributing to an IRA. However, once you turn age 70 1/2 you are no longer eligible to claim a tax deduction for saving in a traditional IRA. However, people who are still working in their 70s can continue to save in a 401(k) plan and defer paying income tax on deposits, often until they actually retire. You can also continue to make contributions to a Roth IRA regardless of your age.
Social Security taxes. You might have to pay taxes on part of your Social Security income. If the sum of your adjusted gross income, nontaxable interest and half of your Social Security benefit exceeds $25,000 for individuals and $32,000 for couples, half of your Social Security benefit will be taxable. If these income sources exceed $34,000 for individuals and $44,000 for couples, as much as 85 percent of your Social Security payments could be subject to tax. Income received from a part-time job, dividends, interest, taxable pension payments and withdrawals from traditional 401(k)s and IRAs could all lead to your Social Security benefit becoming taxable. However, Roth 401(k) and Roth IRA distributions in retirement are not typically taxable and probably won't contribute to your Social Security benefit being taxed. "It's very rare that people don't have to pay taxes on Social Security," Podnos says. "If you have any significant income other than Social Security, you're going to have your Social Security at least partially taxed."
Emily Brandon is the author of "Pensionless: The 10-Step Solution for a Stress-Free Retirement."