While your life will undergo many changes when you retire, one thing that won't change is your obligation to pay taxes. Understanding how taxes affect retirement income can keep you from paying more than needed.
How taxation works
Payments you receive from ordinary retirement funds are taxed at regular income tax rates upon withdrawal. They are added to your total yearly income and then taxed at the rate that applies to your income tax bracket. If you have earned income or significant income from sources other than your retirement plan, your retirement plan distributions may put you in a higher tax bracket than when you were working. To avoid this extra taxation, many retirees put off taking retirement plan distributions until the mandatory age of 70½, hoping that by then they will be in a lower tax bracket. Until then, their pre-tax retirement funds continue to grow tax deferred.
The effect of taking a lump sum
If you wish to receive all of your retirement distributions in the same year (as a lump sum), you may find yourself in a higher tax bracket and paying more taxes than you would if you spread out the payments. However, if you were born before 1936, you can use the 10-year averaging option to reduce the burden. With the 10-year option, you'll still have to pay all your taxes when you take out the lump sum, but the tax bracket will be calculated as if you took the distribution in equal payments over a period of ten years. Alternatively, you may be able to roll over a lump sum distribution into an IRA tax-free. This gives you more flexibility in taking taxable distributions later.
The effect of taking minimum distributions
Another way to limit taxes from retirement distributions is to take minimum distributions. If you must draw from your retirement plan before the age of 70½, you should limit your withdrawals to just the amount of cash you need for expenses and the additional taxes. In years when you have larger tax deductions against income, you can take larger retirement distributions that will be offset by these deductions. For example, if you plan to make large charitable donations or if you have business or investment losses that can offset ordinary income in a given year, then that would be a good year to take a larger retirement plan distribution.
Your tax situation in retirement may become even more complicated than while you were employed. Take the time to understand how the tax code affects your retirement plan withdrawals; it could keep more of your money in your pocket.
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