A Guide to How Your Retirement Benefits Will be Taxed

The time for retirement has come for many people, and the taxes assessed on the various types of income will differ. A general rule of retirement living is having multiple sources of income is the best approach. Depending solely on Social Security can leave you in dire straits in a few years. For the younger readers, you need to give this article a read to know what’s coming down the track, even if you have zero confidence in the Social Security program.

There are three major considerations when looking at retirement taxes – the type of income, federal taxes, and state taxes. There is a reason many people move out of their home state and seek tax refuge in other states. There are also real estate considerations, such as swapping out a four bedroom home for a one bedroom condominium since the kids are grown and gone. These and other financial realities directly affect the tax burden retirees will have to deal with for their remaining years.

First, we’ll tackle the most obvious source of income for retirees – Social Security. Generally the monthly benefit check remains untaxable unless you make more than the maximum allowed. You need to know that there are other sources of income that increase your potential for the monthly check being taxed, such as municipal bond interest. The rule of thumb is to divide your total Social Security benefits by two, then add in all your other taxable income. Depending on the amount that number exceeds the maximum you can incur a tax of up to 50 percent on the difference. It appears the government wants retired people not to work.

Some states actually tax Social Security benefits. If you live in Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, or West Virginia you should already know this. However, the rules for what qualifies as taxable income and the tax rates vary from state to state. If you choose not to move to one of these states, we understand.

Pension income is next on the list, and while not as many people have this source of income any more, it is a huge benefit if you do. But the federal government will want its share, as most pensions are subject to federal tax. If you contributed your own money to the pension fund, that money or a portion of it is not subject to federal income tax. The rules can get complicated, so it is best you check with a tax professional to know what to expect. We do know it will be taxed as ordinary income. Also, part of the calculation involves the IRS determining your life expectancy. Talk about invasion of privacy.

Certain states exempt pension income from being taxed: Alaska, Florida, Illinois, Mississippi, Nevada, New Hampshire, Pennsylvania, South Dakota, Tennessee, Texas, Washington, and Wyoming. All the other states you will have to check into and find what their rules are. It is worth noting that Florida and Nevada don’t tax pensions since they have plenty of other ways to get your money.

Finally, we get to what are known as retirement accounts, or more commonly, IRAs, 401(k) plans, and the like. The short version is you will pay taxes on any distributions from these retirement funds as ordinary income. Roth accounts are the exception, so if you have one you are likely to already know why you chose it to begin with. People who do not have a Roth account should take note.

When it comes to state taxes, there are a lucky seven that have zero state tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Again, note the presence of Florida and Nevada on the list.

From these basic guidelines it should be clear where the best states are to move to, and why so many retirees are willing to put up with the occasional hurricane and 9 months of desert temperatures (though there is air conditioning). You might want to think of your working income as an employee as “active income” since there is the possibility of a raise, bonus, or extra hours. The majority of income sources listed here will be more or less fixed, which makes having multiple sources of retirement income even more important.


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