How do taxes change in retirement?


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Retirement brings a lot of changes, one of the most significant being the way you are receiving your income. Instead of coming from your employer, you are getting a Social Security check, possibly a pension, and then taking the rest from the saving vehicles you used while you were working. It is important to be aware of how your taxes are going to change in retirement so you do not make any costly mistakes.

How Social Security affects taxes:

Many people pay federal income taxes on their Social Security benefits. This usually happens only if you have other substantial income in addition to your benefits (such as wages, self-employment earnings, interest, dividends, and other taxable income that must be reported on your tax return). No one pays federal income tax on more than 85% of his or her Social Security benefits, based on Internal Revenue Service (IRS) rules.

If you file a federal tax return as an “individual” and your combined income is between $25,000 and $34,000, you will pay income tax on 50% of your Social Security check. If your income is more than $34,000 you will pay taxes on up to 85% of your Social Security check, depending on your income level. If you file a joint return, the same formula holds: 50% if your income is between $32,000 and $44,000, up to 85% if your income is over $44,000. If you are married and file a separate return, you will pay income taxes on your Social Security benefits, at the same rates. All the talk you hear about “means testing” Social Security is already happening, because more affluent people are taxed on up to 85% of their benefits.

Each January you will receive a Social Security Benefit Statement (Form SSA-1099) showing the amount of benefits you received in the previous year. You can use this Benefit Statement when you complete your federal income tax return to find out if your benefits are subject to tax. If you do have to pay taxes on your Social Security benefits, you can make quarterly estimated payments or choose to have federal taxes withheld from your benefits.

How Medicare affects taxes:

The standard Medicare Part B monthly premium for 2019 is $135.50. If you’re single and file an individual tax return, or married and file a joint tax return, there are additional costs that could apply to you. This is referred to as IRMAA, or the Income Related Monthly Adjustment Amount.

Medicare deducts income tax money from beneficiaries with higher incomes through surcharging Part B premiums and Part D premiums. For an individual, the income threshold is $85,000; for a married couple the threshold is $170,000. If you earn less than that, your Part B premium is $135.50 (in 2019) monthly and Part D costs whatever the insurance company charges you. If you exceed those income thresholds, your Part B premium can be as much as $460.50 monthly per person, and Part D can cost as much as $77.40 plus what the insurance company charges. Most of our clients have Part B and Part D charges deducted from their Social Security checks, which means that many of them with higher incomes can be unaware that they are paying IRMAA until we point it out to them.

For 2019, Medicare uses your 2017 income tax return, so there is a lag effect. There is a way to appeal IRMAA for life changing events. For example, if you were working in 2017 but then retired, and your income was lowered, Medicare will reconsider the IRMAA costs. Other life changing events include marriage, divorce, or job loss. It is not the easiest process, but it can be done.

How Long Term Care affects taxes:

Long-term care insurance also has some income tax implications. Premiums for qualified long-term care insurance policies are tax deductible if they, along with other unreimbursed medical expenses, exceed 10% of the insured’s adjusted gross income. The amount of deduction is going to depend on your age. The deductible amount increases as you get older.

Benefits you receive from a qualified long-term care policy are received tax free up to $370 per day in 2019. This is approximately $11,000 per month.

Nursing home and home health-care costs can be a deductible medical expense. Generally, you can deduct only the amount of your medical and dental expenses that exceed 10% of your adjusted gross income (AGI). You can learn more about this in the IRS’s Publication 502: Medical and Dental Expenses.

How IRAs affects taxes:

The tax code allows you or your employer to transfer earned income into your IRA, 401(k), 403(b), and similar types of accounts, without paying income taxes or payroll taxes—for now. The earnings or growth inside of these accounts is tax-deferred—for now. Ordinary income taxes must be paid when distributions are taken from your IRA.

If you distribute your IRA before age 59½, an additional 10% penalty will be applied.  At age 70½, the IRS requires you to start taking money out of your IRA even if you don’t want or need it. This is called Required Minimum Distributions (RMDs). If you are over 70½ and don’t need to live on your minimum distribution from your IRA, consider donating your distribution through a Qualified Charitable Distribution (QCD).It is a very tax-efficient way to make charitable contributions. Remember, if you do start taking RMDs, which can push you into a higher tax bracket, you could incur more taxes on your Social Security as well as IRMAA surcharges on your Medicare. We have clients take big distributions from their IRAs which cause them to lose a large chunk of money in taxes because they did not properly plan.

With a Roth IRA, you deposit after-tax earned income. Earnings or growth accumulate tax-free inside a Roth IRA. Distributions from your Roth IRA are tax-free during your lifetime, providing you leave the money in the Roth for at least five years. It is possible, and might be to your advantage, to convert your traditional IRA to a Roth IRA. In doing so, you pay income taxes on your traditional IRA. Roth IRAs have no Required Minimum Distributions during your lifetime. Once again, doing this without a thought out plan can cause you to incur IRMAA surcharges or higher taxes on your Social Security.

How investments affects taxes in retirement:

Investment income incurs income tax in the year it is earned and received. Capital gains and dividends are currently taxed at significantly lower rates than ordinary income. Income accrued inside of annuities and life insurance policies is not taxed until it is withdrawn. If you do not itemize deductions, you are entitled to a higher standard deduction if you are age 65 or older at the end of the year. Capital assets like real estate, a business, and/or stocks and bonds receive a step up in basis at the death of the owner. Your estate must file an income tax return for the year you die. Below is a summary of how different types of investment income are taxed. 

  • IRAs: Tax-deferred until withdrawn. Taxed as ordinary income.
  • Roth IRAs: Tax-free.
  • Life Insurance: Cash value increases are tax-deferred until withdrawn, then taxed as ordinary income. Death benefits generally go to beneficiaries with taxes due on deferred gains.
  • Stocks Held Individually: Capital gains tax is due on sale profits if the stock is held longer than 12 months. Dividends are taxed at capital gains rates.
  • Bonds Held Individually: Interest is taxed as ordinary income. Capital gains tax is due on sale profits if the bond is held longer than 12 months.
  • Bank CDs: Held Individually Interest is taxed as ordinary income.
  • Mutual Funds: Income tax liability is passed through to the holder of the mutual fund. It’s paid as ordinary income tax or capital gains tax.
  • Estate Taxes: “There Are Income Taxes Even in Death” The estate files an income tax return for the year in which the death occurred. Several considerations come into play, including “Income in respect of a decedent.”

How estate planning affects taxes:

Estate planning and estate settlement have many income tax implications. The first thing to know is that life insurance proceeds are received income tax free by most beneficiaries. Second, it’s important to remember that income taxes have to be paid for the year in which a person dies. Depending on the situation, that could be complicated and/ or expensive. Third, the inherent gains in property values are stepped up in basis when a property owner dies. If a client has a farm he bought for $200,000 many years ago and he sold it for $1,000,000 today, he would owe capital gains taxes on $800,000. If the property is held until death and passed on, his heirs receive it at a basis of $1,000,000. If the heirs sold it soon after, they would probably owe no capital gains tax.

This brief overview should suggest to you that there are simple ways to minimize the taxes you pay in retirement—if you know the mechanics of how various assets work, and the details of tax law. There can be great value to you in consulting with an expert who can look at your entire retirement plan, not just taxes.

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