A recent study by the Employee Benefit Research Institute found that housing and healthcare, predictably, are the two biggest expenses faced by seniors during retirement.
But the third-largest retirement expense is a bit more surprising: taxes.
That includes taxes on Social Security income and taxes related to payouts from 401(k)s or IRAs.
Nancy Tengler explains what taxes retirees can expect:
We probably don’t consider that we will most likely have to pay taxes on our Social Security income once retired. According to a February 2012 article on kiplinger.com, “Up to 85 percent of Social Security benefits are taxable,” and the income threshold that triggers income taxation is $32,000 for a married couple. Not a very high hurdle to say the least.
In other words, the vast majority of us will have to pay taxes on Social Security income we receive after years, even decades, of paying into the mandatory government retirement program and doing so with what are considered “after-tax dollars” (according to ssa.gov, the official Social Security website).
That isn’t the end of the tax burden hoisted by retirees. Pre-tax contributions to traditional IRAs or 401(k) plans are also taxed upon distribution. Although most of us understand that our retirement funds are accumulated with pre-tax dollars and grow tax-free, we still may be unprepared for the tax bill when we finally do take distributions.
Importantly, the money we withdraw is taxed at our ordinary-income tax rate. So, let’s say that you are in the 25 percent tax bracket and you find yourself with a $10,000 health-care bill. You will need to withdraw $12,500 to cover the expense and the $2,500 tax bill.
Tengler goes on to suggest ways to relieve that tax burden:
There are various tax-planning strategies that can be employed by retirees. One obvious strategy is to deplete taxable assets first. Another we discussed a few weeks back: the possibility of converting a traditional IRA to a Roth.
Even better, if you are young enough and meet the income restrictions, you may want to start contributing to a Roth now. Roth IRAs do not mandate the annual required minimum distribution at 701/2 like a traditional IRA, and distributions are tax-free. Consult your financial adviser or begin your research now. The plethora of comprehensive research and advice available online is an extraordinary boon to the average individual.
Tengler is the author of “The Women’s Guide to Successful Investing.”
Photo Credit: 401(K) 2012 via Flickr Creative Commons License
