2/2/2012 2:30 PM 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.)
Annuities: The first withdrawals are considered earnings, which are subject to ordinary income taxes plus a possible 10% penalty if you're under 59½. Once the earnings are exhausted, the contributions are not taxable when they're withdrawn. If you annuitize your payments, the portions of them that are considered to be earnings are taxable.
Life insurance cash value: Withdrawals of cash value are the opposite of annuities since they are considered to be nontaxable contributions first and then earnings taxable at ordinary rates. You can borrow from the cash value without paying any tax, however.
Interest: Interest income from things like savings, CDs and bonds outside your retirement plans is subject to ordinary income tax. Since these investments are taxed at the highest rate, they're the first investments you want in your annuities and traditional retirement accounts. (You may want to hold the most aggressive investments in the Roth accounts since the earnings could be tax-free.)
If you're in a high tax bracket, you may also want to consider switching to federal tax-free municipal bonds and money market funds for nonretirement taxable accounts. By picking ones from your own state, you avoid high state income taxes as well. Either way, just be aware that these bonds carry a higher risk of default than federal bonds, as well as bank accounts insured by the Federal Deposit Insurance Corp.
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