Despite retirement, your relationship with the IRS and paying taxes won’t end

Social Security benefits

Social Security benefits are a crucial source of retirement income for many Americans. However, depending on your income level, a portion of your Social Security benefits may be subject to federal income taxes. If your combined income (which includes your adjusted gross income, nontaxable interest and half of your Social Security benefits) exceeds certain thresholds, up to 85% of your benefits may be taxable. For single filers as of 2024, the thresholds are $25,000 and $34,000, while for married couples filing jointly, the thresholds are $32,000 and $44,000.

Pension income

Pension income is another common source of retirement income. Most pensions are funded with pre-tax dollars, which means that the payments you receive in retirement are generally taxable as ordinary income. However, if you contributed after-tax dollars to your pension, a portion of your pension income may be tax-free. It's important to understand the difference between qualified and non-qualified pension plans, as this can impact how your pension income is taxed. Qualified plans, such as traditional defined-benefit pensions, are typically funded with pre-tax dollars and are subject to IRS regulations. Non-qualified plans, on the other hand, are funded with after-tax dollars and offer more flexibility in terms of contribution limits and distribution rules.

IRA and 401(k) withdrawals

Withdrawals from traditional IRAs and 401(k) plans are generally taxed as ordinary income in retirement. This is because these accounts are typically funded with pre-tax dollars, allowing you to defer taxes on your contributions and earnings until you start taking distributions. The tax rate on a 401(k) after 65 is the same as your ordinary income tax rate, as there is no specific age at which you stop paying taxes on retirement income. On the other hand, withdrawals from Roth IRAs and Roth 401(k) plans are tax-free in retirement, as long as you meet certain conditions. To qualify for tax-free withdrawals, you must have held the account for at least five years and be at least 59½ years old (with some exceptions for early withdrawals due to disability or death).

Investment income

Investment income, such as interest, dividends and capital gains, is also subject to taxes in retirement. The tax treatment of investment income depends on the type of investment and your income level. For example, long-term capital gains (from investments held for more than one year) are taxed at lower rates than ordinary income, while short-term capital gains are taxed as ordinary income. To minimize the tax impact of investment income in retirement, consider strategies such as tax-efficient investing, which involves choosing investments that generate more favorable tax treatment (for example, qualified dividends or tax-exempt municipal bonds).

Required minimum distributions (RMDs)

Required minimum distributions (RMDs) are mandatory withdrawals that you must take from certain retirement accounts, such as traditional IRAs and 401(k) plans, once you reach a specific age. As of 2024, the age at which RMDs must begin is 73 for individuals born between 1951 and 1959, and 75 for those born in 1960 or later. RMDs are calculated based on your account balance and life expectancy, using tables provided by the IRS. Failure to take your RMDs can result in a penalty equal to 25% of the amount you should have withdrawn. It's crucial to stay on top of your RMDs to avoid these penalties and ensure that you're meeting your tax obligations.

Standard deduction vs. itemized deductions

Retirees have the option to take either the standard deduction or itemize their deductions when filing their tax returns. The standard deduction is a fixed amount that reduces your taxable income and is adjusted annually for inflation. For the 2023 tax year, the standard deduction is $13,850 for single filers and $27,700 for married couples filing jointly. If your itemized deductions (which may include medical expenses, charitable contributions and state and local taxes) exceed the standard deduction, it may be more beneficial to itemize.

Medical expense deductions

Medical expenses can be a significant cost in retirement, and fortunately, some of these expenses may be tax-deductible. If you itemize your deductions, you can deduct qualified medical expenses that exceed 7.5% of your adjusted gross income (AGI). Qualified expenses include health insurance premiums, long-term care insurance premiums (subject to limits based on your age) and out-of-pocket costs for medical services and prescription drugs.

Charitable contribution deductions

Charitable contributions can also provide tax benefits for retirees who itemize their deductions. Cash donations to qualified organizations are generally deductible up to 60% of your AGI, while donations of appreciated assets, such as stocks or real estate, can be deducted at their fair market value, up to 30% of your AGI. If your contributions exceed these limits, you can carry the excess forward for up to five years.

Tax credits available to seniors

In addition to deductions, there are several tax credits available to seniors that can reduce their tax liability dollar-for-dollar. One such credit is the Credit for the Elderly or Disabled, which is available to taxpayers aged 65 or older, or those who are permanently and totally disabled. To qualify, your income must be below certain thresholds, which vary based on your filing status. Another potential credit is the Retirement Savings Contributions Credit (Saver's Credit), which provides a tax credit for low- to moderate-income taxpayers who contribute to a retirement account, such as an IRA or 401(k).

• Diversifying retirement income sources. One effective strategy to minimize taxes in retirement is to diversify your income sources. By having a mix of taxable, tax-deferred and tax-free income, you can better manage your tax liability and potentially stay in a lower tax bracket. For example, having a combination of traditional IRA withdrawals (taxable), Social Security benefits (partially taxable) and Roth IRA withdrawals (tax-free) can provide more flexibility in managing your tax burden.
• Roth conversions. Another strategy to consider is a Roth conversion, which involves transferring funds from a traditional IRA or 401(k) to a Roth account. While you'll have to pay taxes on the amount converted in the year of the conversion, future withdrawals from the Roth account will be tax-free (assuming you meet the requirements). This strategy can be particularly beneficial if you expect to be in a higher tax bracket in retirement or if you want to leave a tax-free inheritance to your beneficiaries.
• Charitable giving. Charitable giving can also play a role in minimizing taxes in retirement. One strategy to consider is a qualified charitable distribution (QCD), which allows taxpayers aged 70½ or older to donate up to $105,000 per year directly from their IRA to a qualified charity. QCDs can satisfy your RMD requirement and are excluded from your taxable income, providing a tax-efficient way to support your favorite causes.
• Tax-loss harvesting. Tax-loss harvesting is a strategy that involves selling investments that have declined in value to offset capital gains or ordinary income. By realizing a loss, you can reduce your taxable income and potentially lower your tax bill. Keep in mind that the wash sale rule prevents you from claiming a loss if you buy a substantially identical investment within 30 days before or after the sale.
• Timing of retirement income and expenses. Finally, the timing of your retirement income and expenses can also impact your tax situation. For example, if you have the flexibility to defer taking Social Security benefits or IRA withdrawals until a later age, you may be able to reduce your tax liability in the early years of retirement. Similarly, bunching deductible expenses (such as medical costs or charitable contributions) into a single tax year can help you exceed the thresholds for claiming these deductions and maximize your tax benefits.

One question that often arises for retirees is whether they need to pay estimated taxes. The answer depends on your individual tax situation. If you receive income that is not subject to withholding, such as interest, dividends or rental income, you may need to make estimated tax payments to avoid underpayment penalties. The IRS requires estimated tax payments if you expect to owe at least $1,000 in taxes for the year and your withholding and refundable credits cover less than 90% of your current year's tax liability or 100% of your previous year's tax liability (110% if your AGI was more than $150,000).

To determine if you need to pay estimated taxes, consider working with a financial professional who can assess your specific situation and help you navigate the complex world of retirement taxes. They can also assist you in developing a tax-efficient retirement income strategy that minimizes your tax burden and ensures you meet your estimated tax obligations.

Because tax laws are constantly evolving, it's crucial to stay informed about changes that may impact your retirement income and tax obligations. For example, the Setting Every Community Up for Retirement Enhancement (SECURE) Act, passed in 2019, made significant changes to retirement account rules, including increasing the age for RMDs and eliminating the stretch IRA for most non-spouse beneficiaries. Staying up-to-date on these changes can help you make informed decisions about your retirement income and estate planning strategies.

Given the complexity of retirement taxes, it's often beneficial to work with a financial professional who can provide personalized guidance based on your unique circumstances. These professionals can help you develop a comprehensive retirement income plan that takes into account your tax situation, financial goals and risk tolerance. They can also assist with strategies to minimize your tax liability, such as Roth conversions, charitable giving and tax-efficient investing.

It's also important to regularly review and update your retirement tax strategies to ensure that they remain aligned with your goals and the current tax environment. As your financial situation changes or new tax laws are enacted, you may need to adjust your approach to minimize taxes and maximize your retirement income. Working with a trusted financial professional can help you stay on track and make informed decisions throughout your retirement years.

When considering the best states for taxes in retirement, several factors come into play, such as income tax rates, property taxes, sales taxes and the taxability of retirement income. Here are some of the states that are generally considered the most tax-friendly for retirees:

• Alaska. No state income tax. No sales tax. Low property taxes.
• Florida. No state income tax. No tax on retirement income. Relatively low property taxes.
• Nevada. No state income tax. No tax on retirement income. Low property taxes.
• South Dakota. No state income tax. No tax on retirement income. Low sales and property taxes.
• Wyoming. No state income tax. No tax on retirement income. Low property and sales taxes.
• Tennessee. No state income tax (as of 2021). Low property taxes. No tax on retirement income.
• Texas. No state income tax. No tax on retirement income. Relatively high property taxes, but homestead exemptions are available.
• Washington. No state income tax. No tax on retirement income. Relatively high sales taxes, but low property taxes.
• New Hampshire. No state income tax (only taxes interest and dividends). No sales tax. Relatively high property taxes.
• Delaware. No sales tax. Low income tax rates. No tax on Social Security benefits.

It's essential to consider your individual circumstances and consult with a financial professional when deciding on the best state for your retirement. Factors such as your sources of retirement income, lifestyle preferences and overall cost of living should also be taken into account.

Dealing with the complex world of retirement taxes can be challenging, but understanding your tax obligations and developing strategies to minimize your tax burden is crucial for a successful retirement. By familiarizing yourself with the various types of retirement income and their tax implications, staying on top of required minimum distributions and taking advantage of available deductions and credits, you can keep more of your hard-earned money in your pocket.

Additionally, implementing strategies such as diversifying your income sources, considering Roth conversions, engaging in tax-efficient charitable giving and managing estimated tax payments can further help you minimize taxes in retirement. However, it's essential to remember that tax planning for seniors is not a one-time event, but rather an ongoing process that requires regular review and adjustment.