2/2/2012 9:32 AM ET|
Could taxes derail your retirement?
Estimating how your retirement income will be taxed can be complicated and difficult, but it's important to know what this expense will be and how you might reduce it.
We recently received a question from a woman who was trying to see if she could afford to take an early-retirement package but wasn't sure how much of her income she should budget for taxes. Too often people think about how much income they'll need to maintain their standard of living without factoring in the impact of taxes.
Overestimating taxes can lead you to delay your retirement unnecessarily. Even worse, underestimating taxes can potentially derail your retirement plans, since you could end up with a lot less income to spend than you had planned for.
Unfortunately, this is one retirement expense that can be particularly difficult to estimate. That's because taxes are a function of not only how much income you have but also what kind of income and even what state you live in. Let's take a look at how different potential sources of retirement income are taxed and how you might be able to reduce those taxes.
Home: If you decide to sell your home when you retire, $250,000 (or $500,000 if the home is owned by you and your spouse) of the gain is tax-free as long as you lived in it for two out of the past five years. That means you shouldn't rent it out for more than three years if you don't want to pay taxes on a lot of gain when you sell.
Pension: If you're fortunate enough to receive a pension, the payments are taxed as ordinary income, which means they're taxed at progressive tax rates just like your salary but without the FICA portion. (The FICA amount for 2011 is 1.45% for Medicare and 5.65% on incomes up to $106,800 for Social Security, so you can expect your after-tax pension income to be that much higher than the same amount of wages before taxes.)
There are a couple of traps to be aware of. If you take your pension while you're still working, the extra income could push you into a higher tax bracket, so you may want to delay your pension until you stop working. If you take part or all of your pension as a lump sum, you'll have to pay taxes on the lump sum, which could also bump you into a higher tax bracket, plus a possible 10% penalty. You can defer taxes by rolling the lump sum into another retirement plan like a 401k or IRA.
401k and IRA withdrawals: Withdrawals from traditional 401k and IRA accounts are also taxed as ordinary income and can be subject to a 10% penalty if you're under age 59½. With a 401k, one way you can avoid that 10% penalty is if you turn 55 or older the year you leave the company. If you qualify for that exception, you may not want to roll your 401k into an IRA for that reason until you reach 59½. (Will your 401k provide enough for retirement? Find out with MSN Money's calculator.)
Even if you don't need to take withdrawals, you'll be required to take minimum distributions each year starting when you turn 70½. The amounts are based on your life expectancy and are fully taxable. This is just the government's way of making sure it gets its cut.
With Roth accounts, the withdrawals are not considered taxable income as long as you're over 59½ and the account has been open for at least five years. Even if you don't meet those qualifications, you can still withdraw the sum of your contributions at any time and for any reason without tax or penalty. In either case, Roth withdrawals make the most sense in a year when your income tax bracket is higher than normal (such as when you're working). Otherwise, it's best to delay them as long as possible and let those tax-free earnings accumulate.
You can convert your traditional retirement accounts into Roth accounts, but you'll have to pay a tax on whatever amount you convert. It's generally not a good idea to convert if you have to take money from the account to cover the taxes or if you'll be in a lower tax bracket when you eventually withdraw the money from the Roth. But since Roth IRAs aren't subject to required minimum distributions (although Roth 401k accounts are), you may be able to save more in taxes over the long run if you can afford to pay the tax on the conversion with outside money. (Should you move to a Roth IRA? Check MSN Money's conversion calculator.)
More from Forbes:
VIDEO ON MSN MONEY
Retirement a thing of the past, Joey?
Sheesh, what have I been doing since the summer of 2001.
Never worked for Facebook, either. Don't even use it.
Will taxes derail your retirement? Don't know so much about wether or not that may happen but you can be damn sure of one thing. Taxes will always go up unless you can buy off the man who pays the tax man to come take your money. If you don't have that kind of money, then you will pay more taxes no matter what.
Government never does with less. It is always more and more. Go look into the funding that any government program recieves. They all have a budget, if they come in under budget they will get less money the next year. Just ask the one who is head of that program about funding. They might tell you the truth. No program will ever come in under budget. Every one of them will spend their entire budget before the end of the year. Many will just use it to throw a party. This way they will get the same money the next year and they will request more. Often they will get more the next year. They will call it a cost of living adjustment or some other nice name to cover the fact that is it nothing more than fiscal wastfulness disguised as said adjustment.
Either way they will get more. The only way that government gets money, that they will account for, is through taxes and this funds their programs. You can ignore all the hidden money in the background that flows between the special interests and politicians, shhh it isn't happening, it is just your imagination... So your taxes will go up no matter what as they make more and more programs and as those programs waste more and more just by the very nature of how they work or don't.
The next most wonderful thing is that in general government will never do with less. When the work force dwindles and they need to bring in a trillion dollars per year for 150 or so people and that force shrinks to say 100 million or so per se. the goverment will seek way to raise taxes Understand that just because 50 million+ Baby Boomers are retiring, they might not be replaced in the work force. So government will adjust accordingly, 33% or so in the case, to keep bringing in that trillion. But since they always grow, they always want more than that as it goes.
Now if we get say 50 million more who will work enough to pay pensions and taxes for the rest of us and work for peanuts... hmmm. Since the average age of the American is about 37 yrs old. It sure isn't going to be an American that will do that. Unless maybe they have no other choice and are about to be homeless or starving... Ahhh that will never happen. It will be just fine. All is well. Move along, move along. The Dream is American, don't wake up. Have to love this game today.
Will taxes derail your retirement? Maybe. Will your retirement not be what you think it will be because of taxes? Yes Will taxes potentialy ruin the plans you have for your retirement.? yes. Could taxes derail your retirement? Yes. Should taxes derail tyour retirement. No. You just have to love the press and government for how they will pose a question. Without a doubt they are masters of rhetoric in it's classic and most pure definition.
The article has a lot of good information, however does NOT help those HIT by this recession!
Many not wanting to retire were forced out of the workforce, prematurely. Most of the "rules" explained in the article still hold true, but doesn't help those affected.
If you haven't worked in a year, Unemployment (what little it does help) runs out and YOU're Hungry, have BILLs to pay, going after these sources is sometimes, UN-avoidable. With penalties or not, they are the last resort of many.
Thanks for the information MSN, but doesn't help, if your one that has "Slipped through the Cracks".....
Taxes are not the only government threat to retirement. Local fees in my city have risen at least 10% annually with no commensurate increase in the quality or frequency of service, i.e. trash, sewer, street cleaning.
Parking ticket fines increased similarly. A simple, minor parking tickets costs $58. Moving violations cost a minimum of $242. The government is balancing the budget on the backs of the accused. To go to trial takes a year and one must post cash bail in the amount of the fine to go to trial.
With the lack of foresight of the politicians and lack of accountability of the finance advisors, pension costs are skyrocketing. The California Legislature even voted to allow their select staffers to buy "air time" to increase pension pay for time they did not work.
Working class taxpayers have no chance. Retirement is an illusive dream.
"If you take your pension while you're still working, the extra income could push you into a higher tax bracket, so you may want to delay your pension until you stop working"
Not sure I agree with this statement. As long as the pension isn't time limited (most aren't), you may pay more marginal taxes on your non-pension income, but your take home would still be greater with the combined pension and non-pension income.
Several years later, after 8880 is no longer a HUGE advantage convert that accumulated IRA as long as effective tax rate is below 28%, you are paid - paid quite well to convert for future tax free retirement...of course, pay those taxes with non-conversion cash to avoid a nasty penalty.
Young Al and Brenda have a 6 year old daughter they file a joint return
Al has 15,299 in wages
they got a nice refund last year of 1000 from child credit and EIC
they have 160 in dividends
they also (bear with me here) won a radio prize worth 2,800 and hit the slots for 3,700 this year - unlikely, but this is for effect - helps the EIC...
they decide to put last years refund to work in an IRA and also put 3000 into an IRA too - total 2000 each
AGI ends up being 33939
tax is 1108
Form 8880 credit eats up the tax at 1108, 0 tax
This year EIC 1152 refundable
this year child tax credit 1000 refundable
Nice start on next year's IRAs
rinse and repeat. Convert when ready.
Copyright © 2013 Microsoft. All rights reserved.