Retiring Soon? Don't Forget Tax Implications

If your retirement is not far off, you've probably already started to estimate what your living expenses will be after the regular paychecks stop. Most would-be retirees remember to include routine expenses like housing (rent or mortgage), medical bills and prescriptions, insurance premiums, transportation -- even food and entertainment.

But don't forget to factor in taxes, which can have a substantial impact on your cost of living, depending on where you live and what your sources of retirement income will be. What's more, many people don't realize that if they start collecting Social Security while they're still working, their benefit amount could be reduced significantly.

Here are a few tax-related issues to consider when budgeting for retirement:

Taxes on Social Security benefits. Most people can begin collecting Social Security benefits as early as age 62, albeit at significantly reduced amounts than waiting until "full retirement age." (Full retirement age is 65 for those born before 1938 and gradually increases to 67 for those born in 1960 or later. Use this Social Security Retirement Age Calculator to determine your full retirement age.)

It's important to remember that even though many states don't tax Social Security benefits, they are counted as taxable income by the federal government. So, depending on your "combined income" (adjusted gross income plus nontaxable interest earned plus half of your Social Security benefits), you could end up owing federal income tax on a portion of your Social Security benefit. The formula is complicated, but basically:

  • Single people whose combined income is less than $25,000 are not taxed on their Social Security benefit. For combined income between $25,000 and $34,000, you will be taxed on up to 50 percent of your benefit. For income over $34,000, up to 85 percent of your benefit may be taxable.
  • For married couples filing jointly: benefits are not taxable for combined income below $32,000; benefits for income between $32,000 and $44,000 are up to 50 percent taxable; over $44,000 they are up to 85 percent taxable.
  • For married people filing separately who live apart the entire year, the same thresholds as for filing jointly apply; however, if you file separately but live in the same household at any time during the year, your entire Social Security benefit likely will be taxable to some extent.
  • Note that some or all of any pension or annuity payments you receive from a qualified employer retirement plan also may be taxable. See IRS Tax Topic 410 for details.
  • To learn more about taxation of Social Security benefits, read IRS Publication 915.

Working and Social Security. Some people discover after beginning to collect a reduced Social Security benefit before full retirement age that they can't make ends meet and must go back to work. But this can backfire: If your wages exceed $15,120 in 2013, you will lose $1 of Social Security benefits for every $2 you earn over that amount. (Note: investment income doesn't count toward the limit.)

If you will reach full retirement age during 2013, the benefit reduction drops to $1 for each $3 you earn above $40,080 until the month you reach full retirement age. After that, there is no further reduction. So, if you think you'll need to continue working to make ends meet, you might be wise to hold off collecting Social Security until reaching full retirement age, if possible.

Rest assured, however: These benefit reductions are not completely lost. Your Social Security benefit will be increased upon reaching full retirement age to account for benefits withheld due to earlier earnings.

One last point about taxes and Social Security: Any wages you earn after you've begun to collect Social Security retirement benefits are subject to Social Security and Medicare taxes, regardless of your age. To learn more, read What You Need to Know When You Get Retirement or Survivor Benefits.

Taxes on IRA and 401(k) withdrawals. After age 59 ½, you can start withdrawing balances from your IRA without paying the 10 percent early withdrawal penalty -- although exceptions are made in cases including disability, qualified first-time homebuyer distributions and certain medical expenses. Read IRS Tax Topic 557 for rules on early distributions.

Keep in mind that you will pay federal (and state, if applicable) income tax on IRA withdrawals -- unless it's a Roth IRA held for at least five years, whose contributions have already been taxed.

401(k) plan withdrawal rules differ slightly. For example, you can withdraw funds after age 55 without the 10 percent penalty if you are no longer employed by the company sponsoring the plan. For more 401(k) distribution rules, visit this IRS Guide.

Other taxes. Some people move to another state after retirement thinking they'll lower their tax burden. For example, seven states do not tax personal income (Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming); however, another two (New Hampshire and Tennessee) tax only dividend and interest income. And five states charge no sales tax (Alaska, Delaware, Montana, New Hampshire and Oregon).

But because property, local sales, inheritance and fuel taxes and other cost-of-living expenses vary significantly by community, you should only consider such moves after doing thorough research. The Retirement Living Information Center features breakdowns of the various kinds of taxes seniors are likely to pay, state by state, including taxes on income, sales, fuel, property and inheritances.

Bottom line: Be sure to consult a financial advisor long before retirement to make sure you fully understand all the many tax and income implications. If you don't have a good referral, search the Financial Planning Association, the National Association of Personal Financial Advisors or the Certified Financial Planner Board of Standards websites.

This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation.