Planning for taxes in retirement can be tricky since you don't know how tax laws could change before you're able to step away from work. Also, note that tax laws and rules could change dramatically during the decades you spend enjoying retirement. 

Any retirement budget should include taxes, since you’ll still be on the hook to pay some taxes even after you exit the workforce. Here’s what you need to know about taxes in retirement. 

Taxes on Social Security Benefits

When putting together your retirement strategy that involves leaving the workforce between the ages of 65 and 70, don’t forget to account for taxes on your Social Security benefits. The federal tax rate on Social Security benefits is based on your combined income. You can determine your combined income by adding the following: Your adjusted gross income + nontaxable interest + ½ of your Social Security Benefits.

If your combined income is:

• $34,001 or more ($44,001 or more if you’re married filing jointly), up to 85% of your benefits will be subject to federal tax.
• Between $25,000 to $34,000 (or between $32,000 and $44,000 as a joint filer), you’ll be taxed on 50% of your benefits. 

And if you live in any of the 10 states listed below, you could also be subject to state-level taxes on your benefits. The following states are considered not-so-friendly to retirees from a tax perspective: Colorado, Connecticut, Kansas, Minnesota, Montana, Nebraska, New Mexico, Rhode Island, Utah and Vermont.¹ 

Taxes Based on Location

Thinking of relocating during or before retirement? Be sure to factor taxes into your decision. After all, your new location may have a big factor on your taxes. Consider differences in cost of living and healthcare expenses, as well as federal and state taxes. Here’s a shocking example: the median annual health care rate in New York is about $8,208 whereas Hawaii is $6,537. So where you live truly does matter when it comes to having extra money in your pocket.²

And if you plan to leave an estate, that money could also be taxed federally and at the state level if you’re residing in a state that allows this. And that’s the same if you receive an inheritance as well. State inheritance tax rates vary widely, from 1% to 18%, and in most states, the difference is determined by your relationship to the deceased.³ 

Compare retirement costs at different locations to where you currently live with our Cost of Living Calculator. To learn more, check out our class, “How Location Impacts Taxes.” There, you can dive deeper into each state’s individual tax situation as well as any special tax deductions for older Americans. Then, go to our Cost of Living calculator to compare different tax rates and see how moving impacts your Retirement Score.

Taxes on Investment Accounts

Once you’re finally retired, you’ll likely turn to those tax-deferred retirement accounts you’ve been working so hard to beef up over the years. Once you do, remember that you’ll be taxed on any withdrawals you make. The amount will count as ordinary income in the year it’s withdrawn, though at this age, there are no other penalties to worry about. 

These tax-deferred accounts, like a traditional 401(k) or 403(b), SEP, or traditional IRA, are subject to Required Minimum Distributions (RMDs), which are yearly amounts you’re forced to take once you turn 73 (or 72 if you were born before December 31, 1950). RMDs are also treated as taxable income.

If your money is sitting in a Roth account, it can continue to grow untouched, and thanks to the SECURE Act, you can even continue contributing to it. But don’t forget to assign a beneficiary to your Roth IRA, your beneficiary can inherit 10 years of tax-free distributions.

Tax Strategies to Help You Save Money

Yes, taxes are definitely part of retirement. And one thing you may not have considered is the order in which you’ll start drawing down your retirement accounts. But chances are you’ve got money in both taxable and non-taxable accounts, so you can actually minimize the impact to your taxes by putting together a savvy withdrawal strategy. 

How do you know which withdrawal strategy to employ? It depends mostly on the goals you have and your desire to shield yourself from a tax hit as a result of upcoming Required Minimum Distributions (RMDs). Below, we’ve taken an excerpt from our Taxes in Retirement course as a reference. Here, you’ll be introduced to three popular methods of withdrawal sequencing, depending on what your goals are.

Taxable First, then Tax-Deferred

• Withdraw from taxable accounts first (Social Security, annuities, other forms of earned income)
• Then start to draw down tax-deferred accounts (401(k)s, traditional IRAs, etc.)
• Leave the tax-exempt accounts (Roth IRA or Roth 401(k)) for last

Doing this allows you to potentially benefit from a lower tax rate and prioritizes leaving an inheritance for your heirs. Here, accounts with RMDs are tapped early on.

Taxable First, then Tax-Exempt: 

• Drawdown taxable accounts first, like the first method, 
• Then draw down the tax-exempt accounts (your Roth accounts), 
• Finally, start drawing on the tax-deferred accounts (401(k)s, etc.). 

This method reduces your tax bill throughout retirement and can make sense if you anticipate a lower tax rate in the future when you start drawing from the tax-deferred accounts, since those withdrawals will be counted as income. 

Tax Bracket Management: 

• Start with your tax-deferred accounts (e.g., IRA & 401K accounts) first, but only up to a specific tax bracket (e.g. 12%, 22%, etc),
• Then withdraw from taxable accounts,
• Leave tax-exempt funds for last. 

This method prioritizes passing your estate to your heirs and may be a good strategy if you expect a higher tax rate in the future. However, staying within a preferred tax bracket requires a bit of tax knowledge.

Taxes on Inherited Accounts

You may have inherited accounts from your parents or relatives - it’s a great way to add to your nest egg. But there are some tax considerations that come along with it. Typically, any inherited accounts are still subject to RMDs and must be distributed within a 10-year period. These inherited accounts, outside of Roths, count as taxable income and can bump you into a new tax bracket. And depending on where you live, you may incur state taxes, too. If you don’t want to deal with the taxes and responsibilities of real property or creditors, you have an option to disclaim an inheritance. To understand all the tax liabilities and rules that come with an inheritance, go to our course “Taxes in Retirement 101” to get a deeper understanding.

Here are some tax considerations you'll want to keep in mind as you transition to retirement:

• Make sure to plan for Required Minimum Distributions (RMDs) once you reach age 73.
• Consider lowering your expenses so you can minimize withdrawals from retirement accounts, and thus keeping your tax bill manageable.
• Lean on any tax-free money you have for retirement as you plan to minimize taxes owed, such as investments in a Roth IRA or your personal savings.
• Remember that, once you reach age 65 or older, you can use funds from a Health Savings Account (HSA) any way you want, provided you pay income taxes on your withdrawals.
• Consider speaking with a tax professional who can help you find ways to legally lower your tax bill during retirement.
• Next steps: Go to our Retirement School course called “Taxes in Retirement 101” to learn more.

SOURCES

1. Washington, Katelyn, “States That Tax Social Security Benefits.” Kiplinger, 5 September 2023. https://www.kiplinger.com/retirement/social-security/603803/states-that-tax-social-security-benefits. Accessed 4 December 2023.
2. Silvur Services LLC. (2023) Cost Of Living Calculator. Unpublished internal company document.
3. Fritts, Janelle. “Does Your State Have an Estate or Inheritance Tax?” Tax Foundation, 24 February 2021. https://taxfoundation.org/state-estate-tax-state-inheritance-tax-2021. Accessed 1 December 2023.