Don’t Assume Your Taxes Will Be Lower In Retirement

retirement taxes

Franklin D. Roosevelt once said, “Taxes are paid in the sweat of every man who labors.” But I have a not-so-well-kept-secret. You’re also going to have to pay taxes in retirement.

Some of you may be floored upon hearing this. I mean you’re no longer drawing a salary. So, that means that no more payroll and FICA taxes, right?

Don’t Assume Your Taxes Will Be Lower in Retirement

There’s some truth to that. But, even in retirement, you’ll be earning an income. Most likely, this will be in the form of distributions from retirement accounts and Social Security benefits. As such, you still have to pay taxes in your post-work life.

Before you frantically call your financial advisor or whoever is managing your retirement accounts, it’s not all bad news. Despite still having to worry about taxes as a retiree, they probably won’t be as hefty as you may assume.

Why your taxes in retirement may be less than you think.

For starters, not all of your retirement income is taxable.

“When you’re working, the bulk of your income is from your job and is fully taxable (after deductions and exemptions) at ordinary income tax rates,” explains Erik Carter, Senior Resident Financial Planner at Financial Finesse. “When you’re retired, this is only true for pension income, withdrawals from taxable retirement accounts, and any rental, business, and wage income you have.”

“Social Security is taxed at ordinary income rates but only part of it is taxable,” Carter adds. “Withdrawals from Roth accounts are tax-free if you’ve had the account for at least 5 years and are over age 59 1/2.” And, the principal accumulated “from savings and investments is tax-free and long term capital gains are taxed at lower rates or can even reduce your other taxes if you’re selling at a loss.”

Additionally, because your income will most likely be lower, you may actually retire in a lower tax bracket. However, at Charles Schwab remind you that “if your taxable income remains the same in retirement as when you were working, higher rates in the future could boost your tax liability.”

But, what truly matters is your effective tax rate. But, what exactly is this?

“When you’re contributing to a retirement account, you probably want to look at your marginal tax rate,” explains Carter. “That’s the tax rate you pay on an additional dollar of income. The reason being is that “the next dollar that you contribute to your retirement account would normally be taxed at the marginal tax rate.”

How to calculate your effective tax rate.

“Under tax reform, five of seven marginal tax rates were lowered by 1% to 4%,” clarifies Lisa Greene-Lewis, a certified public accountant and TurboTax tax expert. Currently, these rates are 10%, 12%, 22%, 24%, 32%, 35% and 37%. “When it comes to calculating how much tax you have to pay, there is a common misconception that what you are required to pay is based on the marginal tax rate that coincides with your tax bracket and your entire income.”

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