Many of us dream of retirement, of the days when we can kick back and relax, garden to our heart’s content or spend endless summer hours with the grandkids. These and other retirement-related visions are lovely, and you wouldn’t want to ruin them with financial stress or woes. Which is why you should figure out ahead of time how to calculate your federal taxes on retirement income, and make the smartest possible plan for the golden years. So what is federal tax rate on retirement income exactly?
How Is Retirement Income Taxed When You Retire?
Do You Have to Pay Tax on Retirement Income?
The short answer is yes: You do have to pay tax on retirement income. So the next question is, how is retirement income taxed when you retire?
Retirement income may come from several different sources. Some, like an IRA or 401(k), are savings plans into which you have paid over the years you were working. Others, like Social Security income, stem from government programs, into which you also paid during your career. Annuities are another savings vehicle into which you pay in return for a steady payout once you reach a certain age.
You may also have other types of income, such as from real estate investments. For instance, you might receive monthly rent payments from tenants who live in a property you own. Other income types include dividends, interest or gains from the sale of your home or a property.
What Are Pre-Tax Investments?
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It’s important to distinguish between pre-tax and after-tax investments. Pre-tax investments are those into which you deposit investment money before you pay taxes on it. These are also called tax-deferred investments because you get to put off paying money into them until you withdraw it in retirement.
Pension plans and retirement accounts such as traditional IRAs and 401(k)s both use pre-tax income, which means you put money in (with matching contributions from your employer), and it can continue to earn interest on the full amount. Once you withdraw it, it will become income, and you pay taxes at that point.
This serves a dual purpose. While you’re working, you can put money away and reduce your taxable income, so you pay fewer taxes during your earning years. Once you’re retired and on a presumably much smaller fixed income, you will still get taxed on all income, but at a significantly lower tax rate.
Note that there are significant penalties for withdrawing money from these investment vehicles before the specified ages, which are set by the various vehicles independently. Ditto for drawing on your Social Security income, which rewards waiting with higher amounts for later start dates.
How Is Retirement Income Taxed?
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Individuals are taxed on a 1040, according to the pertinent tax tables, which set the rates for income taxes. At each income bracket, you are taxed a greater amount. In the lower brackets, that rate is smaller, while in the higher brackets it grows.
For instance, let’s take the example of the 2017 tax brackets and rates. A single person making between $0 and $9,325, the tax rate is 10% of taxable income. For a single person making between $9,325 and $37,950, it’s 15%. The good news is you only pay 10% on all income up to $9,325, then 15% on income up to $37,950, and so on.
Estimating Your Retirement Tax Income
The best approach is to make a detailed plan for your retirement income long before you actually retire. Once you understand the basic factors that go into retirement income, explained above, you can start putting the pieces together.
It can be helpful to draw up a mock tax return of an average year during retirement. You estimate how much you’ll receive from your pension plan, your retirement plan, your Social Security income, and any additional income from other investments. You then take into account your deductions, whether or not your spouse has income as well, and head to the tax tables to determine what rates you will be taxed at.
Understanding the numbers can help you make the best decisions now for retirement income later. Most likely you’ll need the help of a qualified tax advisor, so get in touch with one today to learn more.
Have you been able to calculate your federal taxes on retirement income lately? Let us know in the comments section below.