After working so hard for so many years and staying on target with your financial goals, you must be looking forward to the blissful relaxation that comes with retirement. This is the mindset of most individuals that put so much work on planning, saving, and sacrificing to meet their goal of retiring comfortably. However, there is one simple question to answer after meeting all of your retirement goals. What tax bracket will you be in after you retire? Seems like a simple question but most people that prepare for retirement can’t really answer if they are going to be in a higher or lower tax bracket when they officially retire.
What Is a Tax Bracket?
Before you can answer which tax bracket you fall in, it is important to first understand what is a tax bracket. A tax bracket is a chart of different levels of incomes, which are separated by your filing status. A filing status is determining if you are filing your taxes as a single person or filing jointly as a married person. Once you identify certain filing information about yourself and your income then you are categorized in a certain group based on that information. That categorized group is called the tax bracket. The different filing status and their meaning are below:
Single Individual: Unmarried person
Head of Household: You are a single person but have a dependent and took financial responsibility for the dependent most of the year
Married Separate: Married couples who live separately or choose to file their incomes and deductions separately
Married Joint: Married and both agree to file a tax return together
Now that we have established what a tax bracket is and how you fall into certain tax categories, we can now look at the different streams of retirement income and how they are taxed by the IRS. Depending on the state that you live in, you can expect certain states to tax you on your retirement income as well.
What Is a Roth Retirement Account?
In simple terms, Roth retirement account is where you contribute dollars after you have paid the tax dollars. When you meet the minimum age to withdraw from your account, your money will be available for you tax free as long as you are 59 and a half or older. A Roth retirement account could be an Individual Retirement Account (IRA) or 401K.
A Roth account will benefit you in retirement if you know that you will be in a higher tax bracket after you have retired from work. When you have already paid your taxes to your Roth contributions when you retire, you will not get taxed twice. So, your Roth money will be available to you tax free.
Traditional IRA and 401K
Traditional IRA and 401K are considered tax deferred retirement accounts. Tax deferred means, the taxes on the money that you put into an IRA and 401K account will be paid when you start withdrawing from the account after you retire. The benefit of this is that you will have more money to investment into your accounts since you are delaying paying taxes until retirement. More money also means more potential investment gains.
Traditional IRA and 401K are considered tax deferred retirement accounts. Tax deferred means, the taxes on the money that you put into an IRA and 401K account will be paid when you start withdrawing from the account after you retire. The benefit of this is that you will have more money to investment into your accounts since you are delaying paying taxes until retirement. More money also means more potential investment gains.
Bonds, Stocks, and Mutual Funds
If you sell these types of financial securities after holding them for more than a year then you will be taxed at a capital gains rate. Capital gains simply means making a profit from your investments. When you make a profit then you will be taxed on those profit gains. The capital gains tax rate can be 0%, 15% or 20% depending on your taxable income bracket. In addition, there is a 3.8% surtax on the net investment income on top of the 0%, 15%, 20%, but this only applies if you are a single taxpayer with a gross income over $200,000.
However, if you sell investments that you have held for a year or less then you will be taxed at your regular tax income bracket. Again, the capital gains tax rate only applies if you are going to make a profit from selling bonds, stocks and mutual funds. This would be not be the case if you sell at a loss. Selling at a loss is a totally different discussion that we will not cover here.
Social Security
When you are receiving Social Security benefits, you are not subject to federal income tax if Social Security is the only income you have coming in. There is something called provisional income that will determine how your social security gets taxed. Provisional income is your adjusted gross income in addition to half of your Social Security benefits, and any other tax-exempt income you received. If you add all of your provisional income and it comes out to be less than $25,000 as a single person, then your Social Security is tax free. If your provisional income is between $25,000 to $34,000 then 50% of your Social Security can be taxable.
We established that the federal government can tax our Social Security benefits depending on the provisional income. What about the individual states, do they tax Social Security as well? Yes, there are states that add on additional taxes as well. There are 12 states that tax Social Security benefits and they all have different requirements on how they do so. The states that tax Social Security are listed below:
Colorado
Connecticut
Kansas
Minnesota
Missouri
Montana
Nebraska
New Mexico
Rhode Island
Utah
Vermont
West Virginia
Financial Planning and Tax Advisor
What I have provided is simple tax information on how you can end up paying taxes into your retirement. The goal is for you to plan for your retirement and not have to give up much of your income that you were earning while you were working. However, does this mean that you will continue to pay taxes into your retirement? Yes, but how much you have to pay is dependent on what tax bracket you plan to be in when you retire. Once you are able to answer this question then the rest is much easier to figure out.
The information I have provided in this article is basic retirement information. For more detailed information regarding taxes, it would be in your interest to have a certified tax advisor. Whether you are still working or retired, get as much information about your taxes as possible in order to avoid paying unnecessary high taxes. There can be solutions to your tax burdens.
