Understanding Taxes in Retirement

Understanding Taxes in Retirement

If you live in the United States, then you know first-hand about taxes that we have to pay. In retirement, those taxes can add up.

Sales tax, income tax, estate tax, and gift tax are just some of the ways that Uncle Sam collects from taxpayers in order to meet his financial obligations.

The subject of taxes is always a hotbutton issue in presidential elections as it is in state elections. With talk of possible tax hikes at present, many people who are retired and nearing retirement are wondering about how they can watch their tax bills.

Fortunately, there are a number of things that you can do to help alleviate, and maybe reduce, the taxes that you owe every year when you file your return.

Here’s a quick, high-level look at the different taxes in retirement that you might face – and what you might want to talk to your financial professional about planning for taxes-wise.

Income Taxes

Income taxes are by far the most prevalent form of taxes in the U.S. today. Everyone who has income of at least a certain amount must file an annual return reporting their income to the IRS.

There are two main types of income tax: ordinary income tax and capital gains taxes.

Ordinary Income Tax

Ordinary income tax means that the taxpayer will be taxed at their top marginal tax bracket. This is the rate of tax that you will pay on all of your earned income for the year, along with Medicare and Social Security tax.

Any type of income from a traditional IRA or qualified retirement plan is also always taxed as ordinary income. Income from annuities is likewise taxed as ordinary income, regardless of whether an annuity is housed inside an IRA or a qualified plan.

Non-qualified annuities are always taxed on a last-in-first-out basis. In simpler terms, some of the income that you will receive from a non-qualified annuity won’t be taxable.

Instead, you will pay ordinary income tax on the growth that your money earned until all of the earnings money is exhausted in the contract. While the growth money is taxable, this is one strategy that you might look at to potentially lower your tax liability on your retirement income.

If you are self-employed, you can lower your adjusted gross income (AGI) if your business is running in the red. Ask your financial advisor and tax advisor for guidance with this situation.

We won’t get into this here, but you might have options to use business losses to help offset earnings from other endeavors. Your tax and accounting professionals can help you learn more about this. They can also talk to you about other options, including using investment losses to offset ordinary income.

Capital Gains Tax

Sales of assets in investment accounts can receive capital gains treatment if the owner held the asset for more than one year to the day. Short-term capital gains are taxed as ordinary income.

The Biden Administration has proposed raising the capital gains tax to 39.6% for those in the top marginal tax bracket. At the time of this writing, this is almost double the rate that they now pay.

If this tax hike becomes law, investors may prompt a quick sell-off of assets as they seek to take advantage of lower rates.

Social Security Taxes

The current Social Security tax rate is 6.2% on all earned income up to a certain level. The IRS specifies the level of earned income that is subject to Social Security taxes each year.  

All income earned below this level must pay this tax, and self-employed taxpayers must pay twice this amount. Those who earn more than the limit don’t have to pay this tax on their excess income, regardless of whether they receive W-2 income or are self-employed.

Self-employed taxpayers can deduct half of their Social Security tax paid as an above-the-line deduction each year.

Taxes on Social Security Income

If your adjusted gross income is above a certain level, then some of your Social Security benefits may be taxed as well.

What does this look like for single filers? If you use this filing status and your income ranges from $25,000 to $34,000, then up to 85% of your Social Security benefits may be counted as taxable income. The income thresholds for marrieds filing jointly are $32,000 to $44,000.

You can reduce the amount of Social Security income that becomes taxable by reducing your other forms of income. If you have retirement accounts with money that hasn’t been taxed yet – for instance, a traditional IRA or 401(k) plan at work – then you might consider opportunities for Roth conversions.

Why? While you might pay taxes upfront, the amount that you pay in taxes might be quite smaller than if you hadn’t moved that money into the tax-free column.

It can help your tax liability on the retirement withdrawals you make for income. What’s more, this can also help reduce the amount of countable income that determines how much of your Social Security benefits might be taxable.

If you have traditional retirement accounts, it’s important to determine how withdrawals might affect your benefits and overall tax picture. Your financial professional and your tax advisor can help you explore whether these tax planning moves make sense for you.

Medicare Tax and Surtax

Medicare taxes are assessed along with Social Security tax for those who earn W-2 income. This tax equals 1.45% of all earned income for the year.

As with Social Security tax, employers pay the other half of this tax, while self-employed taxpayers must pay the entire 2.9%. There is also a Medicare surtax for those with incomes above a certain level.

Those who qualify must pay an additional 3.8% of tax on just about any type of unearned income. This includes taxable interest, non-qualified dividends, realized capital gains, royalties, passive business and rental income, and payments from non-qualified annuities.

Certain income from trusts and estates can also count. Any AGI that exceeds the income threshold can also be taxed. But only the lesser of these two types of income will be taxed.

Some options that might help minimize Medicare surtax are municipal bond interest and tax-deferred annuities. Ask your financial professional for more information.

Gift Taxes

The IRS limits the amount of money or property that one person can give to another each year. Anyone who exceeds this limit will be subject to gift tax. For now, the maximum amount that one person can give another is $15,000.

However, gifts to charity and between spouses have no limit. The same goes for donations to a dependent and also money given to a qualified educational or medical organization on behalf of someone else.

Married couples can give someone $30,000 each year. If you exceed these limits, then you will have to file a gift tax return for that year. Tax rates on the excess amount top out at 40%.

If you are interested in ways to minimize possible gift taxes that you could owe, talk to your financial advisor and tax advisor for more information and guidance.

Estate Taxes

As of now, you are allowed to pass up to $11.7 million to your heirs before you will incur any estate tax. Any assets that are passed to other relatives or organizations will be subject to this tax if they exceed the limit.

The Biden Administration is proposing that the unified credit (the amount that each person can bequest) be reduced to its previous level of $3.5 million.

This could have a major impact on wealthy taxpayers who have used the current level of the unified credit in their estate planning. Estate tax rates are similar to gift tax rates, topping out at 40%.

If Congress passes this proposal or some variant, your estate planning attorney and other relevant professionals can help you explore options to help minimize your tax burden.

The Alternative Minimum Tax

The alternative minimum tax was put in place to ensure that high-income taxpayers must still pay their share of taxes, regardless of how many deductions or credits they can claim.

The AMT calculation is rather complex and requires certain types of income and deductions to be added back into the formula to determine the correct amount that is owed. The income threshold is set by the IRS and is indexed for inflation every year.

If you are in a lower tax bracket, then you can take measures to reduce your AGI. Those can include contributing to your employer-sponsored qualified plan or a traditional IRA. Your tax advisor and financial professional can walk you through this option and others.

State Taxes

State taxes are assessed each year on top of federal taxes, at least for those taxpayers who live in states that levy income taxes. The amount of state tax that each state levies varies widely.

In Kansas, for example, the basic rate of tax is around 5%. But in California, state tax rates run as high as 13.3% in some cases. Find out what you are paying in state taxes and check to see if you qualify for any state tax deductions.

Of course, some states such as Texas and Florida don’t levy income taxes at all.


This is, of course, a very abbreviated rundown on some taxes and what you can do to lower them. Consult with your financial and tax advisors for more information on income taxes and how you can reduce your tax bill now and in the future.

What if you are looking for help with your overall financial picture? Many independent financial professionals are available to assist you at SafeMoney.com. They can discuss ways to plan for taxes, lifelong income, health needs, post-career goals, and other financial matters affecting you.

Use our “Find a Financial Professional” section to connect with someone directly. You can request an initial appointment to discuss your situation. Should you need a personal referral, call us at 877.476.9723.

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