If you dread tax day every year, here’s a bit of good news: Your tax burden probably will lighten when you retire.
You’ll still pay taxes on income you receive from sources that haven’t been taxed yet, such as 401(k) and individual retirement accounts or a defined benefit pension. Your Social Security benefits also may be taxed, depending on your income. And higher-income seniors pay surcharges on Medicare premiums that, while not technically taxes, certainly feel like it to retirees.
But for most households, tax rates fall in retirement, according to research by the Investment Company Institute and the Internal Revenue Service. “Some of the decline is due to the fact that you’re not making payroll tax contributions, but income taxes tend to fall both because your total income is typically lower and because only a portion of Social Security is taxable,” said Peter Brady, senior economic adviser at the institute, a trade group representing the asset management industry.
Careful planning can reduce your tax burden in retirement, experts say. “Being efficient about taxes can have a pretty substantial impact,” said Wade Pfau, an expert on retirement income and author of the “Retirement Planning Guidebook.” “Especially if you have a large I.R.A., some planning can really be helpful.”
Here are the key ways that income is taxed in retirement, and some strategies that can help you be as tax-efficient as possible.
Roughly half of Social Security beneficiaries pay federal income taxes on a portion of their benefits. The tax affects retirees with relatively higher incomes, but the proportion of people who owe taxes is rising.
Taxation of benefits is triggered when certain types of income exceed a threshold. The income formula used to determine this is called “combined income” (also sometimes referred to as “provisional income”). It’s the sum of your adjusted gross income, nontaxable interest and half of your Social Security benefits.
If your combined income is equal to or below $25,000 (for single filers) or $32,000 (for married filers), no tax is owed on your benefits.
Beneficiaries in the next tier of income — between $25,000 and $34,000 for single filers and between $32,000 and $44,000 for married couples filing jointly — pay federal income taxes on up to 50 percent of their benefits. Beneficiaries with income above those levels pay taxes on up to 85 percent of benefits.
Benefits were first taxed in 1984 as part of a reform package signed into law the previous year aimed at stabilizing the program’s finances — the revenue is credited to the Social Security and Medicare trust funds.
The tax thresholds are not indexed for inflation, so more retirees have found themselves paying taxes over the years — and many continue to express frustration about it, said Ed Slott, a tax expert who often conducts educational seminars for consumers and financial planners.
“I’m always getting asked why Social Security benefits are taxed,” he said. “It’s been going on for decades now, but people still complain about it.”
Each January, the I.R.S. will send you Form SSA-1099, which shows the total amount of benefits you received from Social Security in the previous year for purposes of reporting on your tax return. It’s also possible to have taxes withheld from your benefits, by completing Form W-4V.
The U.S. retirement system is structured to provide tax advantages while you save.
Contributions by you and your employer to defined contribution plans are excluded from taxable wages, and investment returns earned on contributions are not taxed. These tax savings provide a powerful benefit that helps your portfolio grow over time.
But income taxes are due when you draw down those dollars.
“Think of your I.R.A. as a joint account with Uncle Sam, because that’s what it is,” Mr. Slott said. “Part of that money is owed back to the government when you draw it in retirement — how much will depend on your future tax rates.”
Most workers approach retirement with the bulk of their savings in tax-deferred accounts. Americans held $37 trillion in retirement assets in the third quarter of 2021, according to the Investment Company Institute — and most of it is in defined contribution plans, I.R.A.s or defined benefit pensions.
It can make sense to diversify your savings during the years when you are saving to include a Roth I.R.A. or Roth 401(k). These accounts are funded with after-tax dollars. No taxes are paid on withdrawals of contributed amounts or investment gains, so long as two key rules on withdrawal are met. First, you must be over 59½ years of age; second, your Roth account must have existed for at least five years.
But from a tax perspective, the value of saving in tax-deferred or Roth vehicles depends on your tax rates now and in the future. “If your income tax rate is the same at the time when you contribute and withdraw, it’s an equivalent outcome,” Dr. Brady said.
Higher-income retirees pay surcharges on their premiums for Medicare Part B (outpatient services) and Part D (prescription drugs). Formally known as Income Related Monthly Adjustment Amounts, they can increase Medicare costs substantially.
The Social Security Administration determines whether you must pay a surcharge using the most recent tax return it can access from the I.R.S. — generally two years before the year for which the premium is being determined. This look-back feature means that the surcharge can be triggered for middle-class workers in the early years of retirement, because it factors in your final years of wage income.
There are five surcharge brackets, defined by your modified adjusted gross income. Medicare enrollees falling into these brackets shoulder a higher share of total program costs. While Medicare sets the standard Part B premium each year to cover 25 percent of total program costs, those subject to surcharge pay 35 percent to 85 percent of those costs.
This year, that translates to a Part B surcharge of $68 a month for a retiree filing a single tax return with modified adjusted gross income between $91,000 and $114,000. Her total premium is $238.10, instead of $170.10. The Part D surcharge is smaller — $12.40 this year for seniors falling into the first bracket.
From there, the surcharge levels jump substantially. And, there’s nothing graduated about them, Mr. Slott notes. “I call it a cliff — if you’re one dollar over, you’re paying the full amount.”
The current high rate of inflation will help some Medicare enrollees avoid surcharges, since the bracket definitions are adjusted annually for inflation. “It does look like we’ll have fewer people paying the surcharges,” said Ron Mastrogiovanni, chief executive of HealthView Services, a Boston-area maker of health care cost-projection software.
The two-year lag effect can create unpleasant surprises when you first enroll in Medicare. It is possible to appeal premium surcharges if your income declined owing to any one of a number of defined “life-changing” circumstances — and one of those is stopping work. File your appeal using Form SSA-44 from the Social Security Administration.
Many states exempt retirement income, although the specifics vary widely. Eight states have no personal income tax, but among those that do, about three-quarters fully exempt Social Security benefits from taxation, and most others have partial exemptions for lower-income retirees, according to research by the Institute on Taxation and Economic Policy, a nonpartisan nonprofit group. Many states also have partial or full exemptions for pension income, and extra personal exemptions or reductions.
“It’s very common for some part of pension income to be exempted at the state level,” said Aidan Davis, the group’s acting state policy director. “And we’re seeing a major trend this year with more states cutting taxes for retirees,” she added.
Strategies for tax efficiency
Careful planning before retirement can help minimize or even avoid some of the knock-on effects that taxes on Social Security and Medicare surcharges can create. The objective is to reduce taxable income wherever possible by diversifying your holdings outside tax-deferred accounts.
Saving for retirement in a Roth I.R.A., or a Roth 401(k) offers one path to achieve this goal, as can Roth conversions, especially in the early years of retirement before you claim Social Security.
For workers enrolled in high-deductible health insurance plans, a Health Savings Account can help. These accounts can be used to pay out-of-pocket health care costs in retirement; contributions are tax-deductible, and investment growth and interest are tax-exempt, as are withdrawals spent on qualified medical expenses. Contributions to these accounts generally must stop six months before your Medicare enrollment becomes effective.
Making charitable contributions from an I.R.A. also can make sense. If you are at least age 70½, you can donate up to $100,000 annually to charities using Qualified Charitable Distributions. No income taxes are due on these distributions, and they also count against your annual required minimum distributions.
This is an especially attractive strategy for retirees who do not itemize deductions on their tax returns, Dr. Pfau said. That often is the case, since seniors typically have fewer deductions, and their standard deduction is somewhat higher (for the 2021 tax year, a single-filing taxpayer age 65 and over can add $1,700 to the standard deduction of $12,550).
“Since these distributions don’t count in your adjusted gross income, they can help with things like Medicare surcharges and taxation of Social Security benefits,” he said.
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