Just like changing jobs or welcoming a new child, retirement is a major life change that significantly impacts one’s tax situation. In this blog post, we’ll explore the common questions surrounding Social Security tax and other retirement tax and provide insights on how you can assist your retired clients in navigating their tax situation post-retirement.
Do retired people pay taxes?
One common question that often arises is whether retired individuals still have to pay taxes. The short answer is yes, they might. Retirement doesn’t necessarily mean a complete escape from the taxman. Income sources like pensions, part-time work, and investment gains can all contribute to a retiree’s taxable income.
The tax burden on retirees depends on various factors such as their overall income, filing status, and specific deductions or credits they may qualify for.
Do you pay taxes on Social Security?
Another significant concern for retired individuals is the taxation of Social Security benefits. Many retirees rely on Social Security as a crucial part of their income in retirement. Not everyone pays taxes on their Social Security benefits, but some do. According to the Social Security Administration, about 40% of people must pay federal income taxes on their Social Security benefits. And those who do pay taxes on Social Security typically have additional, substantial income.
Social Security tax basics
Social Security benefits may be completely exempt from federal taxes or partially taxable up to 85%, depending on the retiree’s combined income. Combined income is calculated by adding your client’s adjusted gross income (AGI), nontaxable interest (such as interest from government bonds), and half of their Social Security benefits.
Up to 50% of their Social Security benefits may be taxable if their combined income is between $25,000 – $34,00 for individuals or $32,000 – $44,000 for couples filing jointly.
If their combined income is greater than $34,000 for individuals or $44,000 for married filing jointly, up to 85% of their Social Security benefits may be considered taxable income. The taxable portion of their benefits would then be taxed according to the federal tax rates for your client’s bracket.
Taxes on retirement accounts and pensions
In addition to Social Security tax regulations, you’ll need to know the basics of tax on other common sources of retirement income. Here’s a brief summary of the tax implications associated with 401(k)s, IRAs, Roth accounts, and pensions.
401(k)s and Traditional IRAs
- Contributions: Contributions to traditional 401(k)s and IRAs are typically made with pre-tax dollars, reducing the individual’s taxable income in the year of contribution.
- Taxation upon withdrawal: Distributions from traditional 401(k)s and IRAs are treated as taxable income. The retiree will pay income tax on the withdrawn amount at their current tax rate.
- Required Minimum Distributions (RMDs): Individuals with traditional retirement accounts are required to start taking RMDs after reaching the age of 72 (or 70½ for those who reached that age before January 1, 2020). Failure to take RMDs can result in substantial penalties.
Roth IRAs and Roth 401(k)s
- Contributions: Contributions to Roth accounts are made with after-tax dollars, so they do not provide an immediate tax deduction.
- Taxation upon withdrawal: Qualified withdrawals from Roth accounts are tax-free. This includes both contributions and any investment gains. Since contributions have already been taxed, retirees enjoy tax-free access to their savings during retirement.
- No RMDs: Roth IRAs do not have RMD requirements during the account owner’s lifetime, making them attractive for those who want more flexibility in managing their withdrawals.
- Taxation of pension payments: Pension payments are generally treated as taxable income. The taxation depends on whether the contributions to the pension were made with pre-tax or after-tax dollars.
- Partial exclusion for after-tax contributions: In cases where a portion of the pension contributions was made with after-tax dollars, a portion of the pension payments may be tax-free. This is known as the “cost recovery” or “after-tax” amount.
Investment property taxes
Retired clients who have invested in real estate may have additional tax considerations. Rental income, capital gains from property sales, and property tax deductions are all factors that can impact their tax liability. Tax preparers should carefully review these aspects to ensure compliance with tax laws and identify opportunities for minimizing the tax burden.
Tax implications of cashing out a 401k
Some retirees may choose to cash out their 401(k) or other retirement accounts to meet immediate financial needs. While this can provide a quick infusion of cash, it can come with significant tax implications. As a tax preparer, you’ll want to guide your clients through the following considerations if they have already or are considering cashing out their 401k:
Increase in taxable income
When an individual cashes out their 401(k), the withdrawn amount is generally treated as taxable income in the year of the withdrawal. This additional income could potentially push the retiree into a higher tax bracket, resulting in a higher overall tax liability. It will also be included in their combined income (discussed above) and could mean that more of their Social Security benefits become taxable.
Early withdrawal penalties
If a retiree is under the age of 59½, withdrawing funds from a 401(k) may trigger early withdrawal penalties. In addition to regular income tax, the IRS imposes a 10% penalty on the taxable amount for early withdrawals. However, there are certain exceptions to this penalty, such as for medical expenses, disability, or first-time home purchases. Tax preparers should be well-versed in these exceptions to provide the most beneficial advice to their clients.
Helping retired clients navigate the intricacies of taxes after retirement requires an understanding of tax laws on Social Security benefits, retirement accounts and pensions, and other sources of income such as real estate investments.