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Retirement should be a time for aging gracefully and pleasurably, without undue stress from the obligation to pay taxes. But giving up a regular paycheck doesn't absolve you from paying taxes. And, perhaps even more than when you were working, the factors that determine your tax bite in retirement are extremely varied and complex. That's why it's a good idea to review your retirement plans during tax season, when your financial information is fresh in your mind, and make any fixes that could help you retain more of your nest egg.
The key element of any review is to make sure that your projected retirement budget includes enough money to cover your anticipated taxes. (If you don't have a plan, see my previous column, "It's Time to Abandon the 70% Solution", outlining the steps involved in arriving at a retirement budget.) To make the best estimate of how much money to put aside for taxes, try to think through the following issues: the sources of your retirement income, the timing for receiving the income, and where you'll live during retirement.
In general, Uncle Sam taxes a traditional pension, or withdrawals from a 401(k) or traditional IRA, at the same rate as money you earn from a job. The amount you pay -- anywhere from 10% to 35% -- will depend on your tax bracket.
CAPITAL GAINS. Julie Welch, a financial planner and accountant in Kansas City, Mo., cautions that even though you've stopped working, if you have a big nest egg, you may remain in the same tax bracket in retirement, because the brackets are quite wide. Currently, the 25% bracket, for example, applies to taxable income ranging from $59,400 to $119,950 for a married couple filing jointly. Check the current Internal Revenue Service tax rate schedules.
So how can you manage to pay taxes at the lowest possible rate? Jackie Pearlman, senior tax-research coordinator at H&R Block in Kansas City, Mo., suggests that if you're retiring soon and have investments outside a retirement account, "you should consider selling the stocks and taking the capital gains, or living on dividends" as long as possible. That's because, for people in a 25% or higher tax bracket, long-term capital gains and most dividends currently incur a federal income tax of 15%. (The rate could change if Congress does not renew the provision, which expires at the end of 2007.)
You may also have to pay federal taxes on your Social Security benefit, but this will depend on your total taxable income in a given year. The worst-case scenario, in which your non-Social Security income exceeds $34,000 for an individual, or $44,000 for a married couple filing jointly, would require you to pay income tax on up to 85% of your benefit. (This is explained in this Social Security Administration document.)
INCOME SOURCES. Age is another key factor in determining when you can, or must, start taking retirement benefits and paying taxes on them. For example, if your dream is to stop working at age 50, what will you live on? You won't be eligible for Social Security for another 12 years. To take money from a 401(k) without a 10% penalty, you must be at least 55; to take it from an IRA, you must be at least 59.5. And the penalty will be on top of the regular income tax you'll owe (see BW Online, 9/23/05, "Tapping Your 401(k) in an Emergency").
Unless your retirement accounts are worth a very large amount of money, and you're willing to pay the penalty, you'll need to tap other sources, such as investments outside those accounts, or possibly income from rental properties, to finance such an early retirement.
Alternatively, let's say you want to work until you're 75 (see BW, 6/27/05, "Old. Smart. Productive"). Once you turn 70.5, Uncle Sam will require you to start taking annual, taxable withdrawals from a traditional IRA on an amount that's calculated based on your life expectancy. (This does not apply to a Roth IRA, for which you've already paid the taxes.) IRS Publication 590, "Individual Retirement Arrangements", spells out these rules in detail. Some employers' retirement plans may require you to start taking 401(k) distributions once you pass 70.5, even if you want to continue working.
Even in "retirement," working means more income, and more income means more taxes. The timing of your departure from the workforce will make a difference in deciding the order in which to tap your retirement income sources. Let's say you plan to leave your main job at 62, and earn $25,000 annually after that as a consultant. If you begin collecting Social Security benefits, and earn more than certain specified amounts of money each year, you'll have to pay taxes on the consulting income, and you also could end up forfeiting one-half or one-third of your benefit due to the "earnings test" described here.
RETIREMENT RESIDENCE. Even if you're partially retired, you'll have to pay Social Security and Medicare taxes on the part-time income. If you have other resources to tap for expenses, you might want to postpone starting on Social Security, both to avoid losing some of your benefit and to allow the size of your benefit to ramp up until you turn 70. After that, the benefit will not increase, except by the annual cost-of-living adjustment.
Another factor is your retirement residence. This refers to both your actual residence -- house, apartment, or whatever -- and its geographical location. Tom Ochsenschlager, vice-president of the American Institute of Certified Public Accountants (AICPA), points out that the real estate boom has endowed many taxpayers with potentially large capital gains on their homes. Currently, each taxpayer who has lived in a home for two of the last five years may exclude from federal taxes a $250,000 profit on its sale.
If you're near or beyond that potential profit level, and don't want to stay in the house forever, consider selling before you retire -- and before you incur any extra taxes. You can invest at least some of the tax-free largesse wisely to feather your retirement nest. And since the IRS allows you to benefit from this provision every two years, you could start the tax clock running on your new home and also sell it -- hopefully for a profit -- before retiring.
LOCATION, LOCATION, LOCATION. Randy Ryan, a senior manager at the AICPA, says you also should consider the potential tax impact of retiring in a different state. The 401(k) withdrawal or pension you receive in New York, for example, will be subject to state income tax. In Florida, it would not.
According to a recent study by the National Conference of State Legislators, seven states have no personal income tax at all. Most of the rest allow taxpayers to exclude some portion of some type of pension or other retirement income. If you're planning to retire in another location, be sure to check the rates on property taxes, which can be a big bite for retirees on a limited income.
You may think that tax season brings enough headaches without having to think about your retirement, too. So, after filing, give yourself a breather of a week or two, before taking on an analysis of your financial plans for retirement. But don't forget! A financial plan that's not updated periodically will be of little value when you finally do retire.
In addition to writing Your Retirement for BusinessWeek Online, Hoffman is the author of The Retirement Catch-Up Guide and Bankroll Your Future Retirement with Help from Uncle Sam. You can contact her through her Web site, www.retirementcatchup.com
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