The biggest difference between managing taxes throughout your career versus during retirement is that when you are retired, you are responsible for calculating how much you owe and paying it on a timely basis. Retirees normally have several different income sources, and not all automatically withhold taxes from distributions.
Retirement Income Sources
Having multiple sources of income during retirement is a good strategy, as it helps protect you from market declines, tax legislation changes and potential defaults or cutbacks in pensions or entitlement programs. However, be aware that the more income sources you have, the more effort it takes to determine how much you owe in taxes for the year.
As a general rule, retirement income is taxed as either ordinary income or long-term capital gains. Ordinary income includes:
Income subject to long-term capital gains is taxed at 0 percent, 15 percent or 20 percent, depending on your total taxable income. This type of income is generated from:
Additional Investment Tax
Single taxpayers may be subject to an additional 3.8 percent net investment income tax (NIIT) on income generated from invested assets – if their modified adjusted gross income (MAGI) is $200,000 or more ($250,000 or more if a married couple filing jointly). Examples of investment assets include interest, dividends, long- and short-term capital gains, rental income, royalty income and nonqualified annuities.
Automate Tax Withholding
One way to make tax planning easier in retirement is to have taxes automatically withheld whenever you take income distributions. Much like having payroll taxes withheld from your paycheck, when you file year-end taxes you reconcile the amount owed by either paying more or receiving a refund.
There are certain income sources on which taxes are automatically withheld, but be aware that a fixed percentage (e.g., 10 percent) may not be the appropriate amount for all taxpayers. The fixed percentage withheld may vary by investment type, and in many cases the account holder can change the default withholding. The following shows how taxes are handled for different retirement income sources.
Develop a Tax Payment Plan
One of the best ways to enjoy retirement is to automate your tax payment plan. You can do this by actively selecting a withholding percentage for each income source you own, and vary it based on the amount and frequency you tend to draw down each year.
Another option is to pay estimated quarterly taxes (due Jan. 15, April 15, June 15 and Sept. 15 every year). This is how most independent business owners and contractors self-pay their taxes in order to avoid an underpayment penalty. This strategy works best if you receive unexpected income throughout the year, earn self-employment income or receive rental or taxable investment income.
The good news is that after your first full year of retirement, you will have set the bar for how much you owe in taxes – referred to as your safe harbor. Thereafter, you’re not subject to an underpayment penalty as long as you pay at least:
Remember that in addition to creating a retirement income plan, it’s important to develop a tax payment plan as well. This will help make tax season go a whole lot easier.
Disclaimer
These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact a professional regarding the topics in these articles. The images linked to these articles are protected by copyright and should not be copied for any reason.
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