How to Manage Taxes in Retirement

You're planning and saving money for a financially secure retirement. Good for you! But don't neglect the one factor that could make an important difference: the impact of taxes on retirement finances.

Many retirees don't consider how taxes will affect their retirement income. As a result, they may end up paying thousands of dollars more in taxes than they would have if they'd planned better.

Different Tax Treatments

A key to managing taxes in retirement is understanding the tax treatment of different types of investment accounts. There are three types of accounts from a tax perspective:

1. Taxable accounts. These consist mainly of brokerage accounts. Taxes are due on investment gains during the year when investments are sold. If investments are held for less than one year, gains are taxed at the seller's ordinary income tax rate. If investments are held for one year or longer, they are taxed at favorable capital gains rates of 0%, 15% or 20%, depending on the seller's adjusted gross income.
2. Tax-deferred accounts. These accounts include traditional IRAs and 401(k)s. Taxes aren't paid until funds are withdrawn in retirement, at which time withdrawals are taxed at ordinary income tax rates. Many people's tax rates are lower in retirement than during their working years.
3. Tax-free accounts. These include Roth IRAs and 401(k)s, which are funded with after-tax dollars. This means taxes have already been paid so funds are withdrawn tax-free in retirement. Tax-free accounts are usually the most beneficial retirement accounts from a tax standpoint.

If you have money in all three types of accounts, one strategy is to withdraw funds from your taxable accounts first, your tax-deferred accounts second and your tax-free accounts last. This will give your tax-deferred funds longer to potentially appreciate. Or you could withdraw money proportionally from all of the accounts, which would stabilize your tax bill over the course of retirement.

Required Minimum Distributions

When you turn 73 years old, you must start taking required minimum distributions (RMDs) from tax-deferred accounts and pay income taxes on these withdrawals. Distributions must begin by April 1 of the year following the year you turn 73 and for subsequent years, they must be made by December 31. (Under the SECURE Act 2.0, the age to begin taking RMDs will then increase to age 75 starting on January 1, 2033.)

Failure to take RMDs may result in a steep penalty of the amount that should have been withdrawn. Before SECURE 2.0 law was enacted in 2022, if you failed to take your RMD for the calendar year in question, the IRS could impose a 50% penalty on the shortfall. SECURE 2.0 reduced the penalty from 50% to 25%, or possibly 10% if you withdraw the shortfall within a "correction window."

The RMD is calculated based on the balance in your tax-deferred account on December 31 of the previous year. This is then divided by the applicable distribution period or a life expectancy factor based on your age. IRS Publication 590-B includes life expectancy tables you can use for this calculation.

RMDs can be minimized, and potentially avoided, by converting a traditional IRA or 401(k) to a Roth account. However, income taxes must be paid on the full value of the account at the time of the conversion, which might not be feasible. Note that if you already are subject to an RMD, you cannot avoid the one for the current year by making the conversion.

Possible Social Security Taxes

If you continue to earn income after you retire, you might have to pay federal income tax on a percentage of your Social Security retirement benefits. To determine if your Social Security is taxable, add any nontaxable interest you earn to your taxable income and half of your Social Security benefit to arrive at your provisional income.

If your provisional income is between $25,000 and $34,000 a year as a single, or between $32,000 and $44,000 a year as a married couple filing jointly, up to 50% of your Social Security benefits will be taxable at your ordinary income tax rate. If your provisional income is more than $34,000 a year, or above $44,000 a year as a married couple filing jointly, up to 85% of your Social Security benefits will be taxable.

Taxes can be withheld from your Social Security benefits by filing IRS Form W-4V. You will choose a withholding percentage of 7%, 10%, 12% or 22%, not a dollar amount. Or you can make quarterly estimated tax payments to avoid a big tax bill (and possible tax penalty) when you file your return.

Plan Ahead

Don't let taxes throw a wrench into your carefully crafted retirement plans. Take steps now to plan for the impact of taxes on your retirement finances.