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Oct. 5, 2020, 10:12 a.m. EDT

Your guide to the tricky tax rules of retirement

Income taxes could be your largest expense in retirement, here’s what you should plan for

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By Kerry Hannon


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Understanding taxes is key to smart retirement planning.

This article is reprinted by permission from NextAvenue.org .

When you’re doing your retirement planning, it’s easy to ignore one vital topic: How much taxes will I owe on my retirement income? Frankly, it’s a hornet’s nest.

But the topic of taxes and your retirement income is vitally important for your retirement planning.

Anqi Chen and Alicia H. Munnell of the Center for Retirement Research at Boston College analyzed data from the federal Health and Retirement Study, on 3,419 recently retired people where at least one earner claimed Social Security benefits from 2010-2018. Their bottom line: When people evaluate their retirement resources, they may forget that a portion will be taxed.

How much of retirees’ income goes to taxes

Chen and Munnell presented their findings in a preliminary paper, “ How Much Taxes Will Retirees Owe on Their Retirement Income ” at the virtual 2020 Retirement and Disability Research Consortium Annual Meeting. (I attended it so you didn’t have to.)

“Households in the aggregate will have to pay roughly 6% of their income in federal income taxes,” they authors wrote.

But the percentage varies greatly, depending on the size of their retirement income.

According to the paper: “Those in the bottom three quintiles [quintiles divide the population study in fifths] pay close to zero, but the rate rises to 1.5% for the fourth quintile and to more than 10.5% for the top quintile, 15.4% for the top 5%, and 20.9% for the top 1%.”

Also see: When it comes to Social Security, these strategies can pay off for married couples

The top quintile includes married couples with average combined Social Security benefits of $33,130; 401(k)/IRA balances of $180,790 and financial wealth of $87,500.

The tax rules for retirees

Income taxes can be your largest outlay in retirement. You’ll pay income tax on any pension and on withdrawals from any tax-deferred accounts —such as traditional IRAs, 401(k)s, 403(b)s and similar retirement plans as well as tax-deferred annuities — in the year you withdraw the funds. (Roth IRA distributions are tax-free.)

And, by law, you must make required minimum distributions (or RMDs) from your retirement plans starting at 72.

If you have investments outside of a retirement plan, such as stocks or bond funds (other than municipal bond funds), you’ll typically pay taxes on their dividends and interest and potentially pay capital-gains tax when you sell them.

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