How taxes can impact your retirement savings and Social Security income

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Understanding how taxes impact your retirement savings and Social Security income is a crucial step in planning for your retirement.

We’ll review some valuable information that can help you maximize your retirement savings and spending.

Taxes on retirement plan withdrawals

Taxes on the money you contribute to a traditional 401(k), 403 (b) are deferred, offering the benefit of reducing your taxable income during your working years. That means, when you start withdrawing from your retirement accounts, the IRS treats your withdrawals as ordinary income. So, the amount you take out is added to your total income for the year and taxed according to your current tax bracket.

If you withdraw large amounts in one year, it could bump you into a higher tax bracket, increasing the taxes you owe. It’s important to carefully plan around your withdrawals to avoid paying more than necessary in taxes. Start by looking at your required minimum distributions to get an idea for how your retirement income may be taxed.

Taxation on IRA withdrawals

If you have Individual Retirement Accounts (IRAs), and the tax treatment of withdrawals depends on whether you have a traditional IRA or a Roth IRA.

With a traditional IRA, much like the 401(k), contributions may have been tax-deductible, and the funds grow tax deferred. Once you begin withdrawals, they are taxed as ordinary income. You’ll need to consider the same tax implications as with a 401(k)—taking out larger sums could push you into a higher tax bracket.

However, if you have a Roth IRA, withdrawals are entirely different. Roth IRAs are funded with post-tax dollars, meaning you’ve already paid taxes on the money before contributing it. Because of this, qualified withdrawals (after age 59½ and having had the account for at least five years) are tax-free.

This is a significant advantage in retirement since you won’t owe any taxes on the income you take from your Roth IRA. For many retirees, having both types of accounts allows for more tax-efficient withdrawal strategies.

Required minimum distributions (RMDs)

You’ve heard of them, but what exactly are they?

RMDs are the minimum amounts the IRS requires that you withdraw each year to ensure that tax-deferred funds are eventually taxed. These withdrawals are taxed as ordinary income. For retirees who have substantial retirement account balances, RMDs can push you into higher tax brackets, particularly if you’re also receiving Social Security or other sources of income.

Failing to take the correct amount as an RMD can result in hefty penalties—50% of the amount not withdrawn. So, it’s crucial to make sure you’re withdrawing at least the required amount each year.

One way to manage the tax impact of RMDs is to start withdrawing earlier (even before RMDs are required) and spreading the distributions over time, possibly when you’re in a lower tax bracket. Additionally, consider Roth conversions before reaching RMD age. By converting some traditional IRA or 401(k) funds into a Roth IRA, you’ll pay taxes upfront, but future withdrawals from the Roth will be tax-free, and Roth IRAs are not subject to RMDs.

Once you turn 73 (or 72 if you were born before 1951), you’ll be required to take Required minimum distributions (RMDs) from your traditional 401(k) and IRA accounts. Want to learn more about RMDs?


State taxes and retirement

While Federal taxes often get the most attention, state taxes can also significantly affect your retirement income. Not all states tax retirement income equally or at all. Be sure to check your state’s tax rules and consider them when planning where to live in retirement.

Some states tax 401(k) and IRA withdrawals but exclude Social Security income from taxation. Others may offer retirement income exemptions or tax deductions that can reduce your overall tax burden. Understanding these differences can help you choose a more tax-friendly location for your retirement.

Planning for taxes in retirement

Consider consulting a financial advisor or tax professional to help you create a tax-efficient strategy tailored to your situation. With the right plan in place, you’ll be better positioned to enjoy your retirement years without being surprised by unexpected tax bills.