Understanding Taxes On Your Retirement Income

Understanding Taxes On Your Retirement Income

Most people spend their working years worried about saving enough for retirement. What tends to escape attention, however, is how that retirement income will be taxed in the future.

Understanding Taxes On Your Retirement Income
Tuesday, 08 October 2019

Depending upon the type of income, retirement earnings are often taxed at a lower rate – or sometimes not at all. It’s important to understand where your retirement income falls on this continuum so that you can ensure you will have the spending power you hope for once you stop working.

Example Scenario

Let’s imagine you’re a single person who earns $80,000 each year, and you save 10 percent for your retirement. After deducting this retirement contribution, income taxes and applicable FICA taxes, you’re likely to have $50,000-$60,000 at your disposal annually. How do you ensure you’ll have this same amount available to you in retirement after taxes? Since that answer is highly dependent upon the source of your retirement income, let’s take a look at a few common sources:

Investment Income

If you hold any investments for less than one year, you will be subject to short-term capital gains tax. This income will be taxed as ordinary income, just like when you were earning a paycheck at your job. For investments held for longer than one year, you’ll face a long-term capital gains tax of up to 15 percent. Stock dividends are generally taxed if you hold them for more than 60 days, at a rate of up to 15 percent, too.

Roth Retirement Accounts

If you’ve got this type of income in retirement, you can pat yourself on the back for good planning. Any qualified distributions from Roth IRAs, Roth 401(k) accounts and Roth 403(b) accounts are tax-free because the money was already taxed once before you put it into the Roth account.

Social Security Income

Though highly dependent upon the amount of other taxable retirement income you have, between zero percent and 85 percent of your Social Security income will be subject to taxation.

Tax-Deferred Retirement Accounts

If you have a traditional IRA, a 401(k), a 403(b), a 457 or a Thrift Savings Plan, any income received will be taxed as traditional income, at a rate of between 10-35 percent.

Calculating What You Need

Your individual scenario is unique to you, but under various typical retirement income scenarios, you would likely need an annual income of $55,000-$62,000 in order to maintain the same quality of life you had when earning an annual salary of $80,000 before retirement.

Of course, the more income you have from tax-favored sources like Roth accounts, the less you will have to pay in taxes. Conversely, if your retirement income is all from Social Security or traditional IRA vehicles, you’ll need to withdraw more each year to make up for the amount that will be taxed. Be forewarned: withdrawing more money to off-set your after-tax income could have the effect of a greater percentage of your Social Security income being subject to taxation.

So, What Does All of This Mean?

Using what we learned from the example scenario, it’s safe to infer a few things:

  1. If you want to maintain your current buying power once you retire, you’ll need about 70 to 80 percent of your pre-retirement income. This is a useful number to know if you’re utilizing a retirement calculator for planning purposes.
  2. The amount of retirement income you will need depends upon the source of said income. More tax-deferred assets means a greater need to withdraw each year.
  3. There are pros and cons to both tax-deferred accounts and Roth accounts. Contributing to tax-deferred accounts get you a tax deduction while you’re still working, which is not available with a Roth account. However, Roth distributions won’t be taxed at all in retirement.

Every retirement scenario is a bit different, and yours may change over time as your assets and investment vehicles change. Most people have more than one source of retirement income, and the same is likely true for you. The important thing is to maintain a focus not just on the amount of money you want to earn in retirement, but also on the amount of taxes you’ll be subject to. Without this important information, your retirement picture will be incomplete and you may find yourself compromising the retirement lifestyle you always dreamed of.

If you’re interested in retirement planning guidance, you may benefit from the services of a financial planning professional. Just make sure to use a fee-only advisor who takes the time to understand your unique retirement goals.

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About the Author

Carroll W. “Bill” Hayes

Carroll W. “Bill” Hayes

Carroll W. “Bill” Hayes, MBA, CFP® Mr. Hayes started his financial career at Merrill Lynch in 1989. In 1992, Bill left Merrill Lynch for Fidelity Investments. During his career at Fidelity Investments he held roles in various divisions of Fidelity. Those roles included positions in the Trust, 401(k), Brokerage, and Money Management divisions. Bill held management positions at Fidelity and in 2001 led a Private Access team based in Boston. In the Private Access role his responsibilities included managing a book of business in excess of $3 Billion and a client base that was international in scope. 

In 2008 Bill established Charles Carroll Financial Partners. The firm is an Independent FeeOnly Financial Planning and Investment Management firm. Charles Carroll Financial Partners embraces its fiduciary responsibility to its clients. 

Bill is a graduate of Marquette University, and holds an MBA from the Sawyer School of Management. Bill holds the designation, CERTIFIED FINANCIAL PLANNER, and currently presides as a Commissioner on the Disciplinary and Ethics Commission of the Certified Financial Planner Board of Standards. Bill resides in Massachusetts with his wife Christine and travels up and down the East Coast meeting with clients of the firm.

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