“Some retirees may be surprised to learn that a portion of their Social Security benefits could be subject to federal income taxes.”
Paying taxes when you aren’t working but are instead receiving income from a lifetime of working and Social Security is a harsh reality of retirement for many people. Figuring out how much of your income will be consumed by taxes is a vital part of Estate Planning, according to the article “What You Need to Know About Taxes and Your Retirement” from Next Avenue.
Most households will pay about six percent of their retirement income in federal income tax, but that number varies greatly, depending upon the size of their retirement income. The lowest income groups may pay next to nothing, but as income rises, so do the taxes. Married couples with an average combined Social Security benefit of about $33,000, 401(k)/IRA balances of $180,790, and personal financial wealth of $87,000 could find themselves paying 10.5% to 20.9%.
Income taxes and health costs are most people’s biggest expenses in retirement. Income taxes are due on pensions and withdrawals from tax-deferred accounts, including traditional IRAs, 401(k)s, 403(b)s, and similar retirement accounts. The same goes for tax-deferred annuities. Required minimum distributions must be taken starting at age 72.
Roth IRA and 401(k) distributions are tax free, since taxes are paid when the funds go into the accounts, not when they are withdrawn.
If you have investments in addition to your tax-deferred funds, like stocks or bond funds, you also pay taxes on the dividends and interest paid to you. If you sell them, you’ll likely need to pay any capital gains taxes.
Learning that a portion of your Social Security benefits are subject to federal income tax is a shocker to many retirees, but about 40% of recipients do pay taxes on their benefits. The higher your income, the more taxes you’ll need to pay.
There may also be state taxes on your Social Security benefits, depending on where you live.
However, here’s the biggest shocker–if you work part time, you may forfeit benefits, temporarily, if you claim before your Full Retirement Age (FRA), while you are working. Claiming before FRA means that your benefits are subject to earnings limits—the most you can make from work before triggering a benefit reduction.
Social Security withholds $1 in benefits for every $2 earned above the annual earnings limitation cap. If you reach your FRA after 2020, that’s $18,240. If you reach your FRA in 2020, the annual exemption amount is $48,600.
Pension, investment income and any government benefits, like unemployment compensation, don’t count towards earned income.
Benefits that are withheld will be returned to you once you hit FRA when Social Security bumps up your monthly benefit to make up for the withholding, but this takes place over time. Consult with your accountant on the income tax aspects of your retirement plan to get your full financial tax outcome during your retirement year.
Reference: Next Avenue (Sep. 17, 2020) “What You Need to Know About Taxes and Your Retirement”