"The taxman cometh every year, and no one knows this better than retirees who spent their working years paying taxes on their earned income. However, as retirees enter a new phase of life, it's important for them to know the various tax rules governing pensions, Social Security, investments, and other types of retirement income. Below are five areas that can cause problems for retirees and possibly increase their tax liability.
Pension PaymentsPension payments may be partially taxable, fully taxable, or not taxable at all, depending on several factors. Brian Ashcraft, regional director of U.S. Corporate Stores at Liberty Tax Services tells Investopedia that a pension will likely be fully taxable if:
On the other hand, Ashcraft says, That pension is partially taxable if they contributed after-tax dollars to it. And, if the retiree started receiving pension payments before age 59½, he says they may have to pay an additional tax on early distributions.
There are also other factors that may determine if the pension is taxable.
John Piershale, CFP, wealth advisor at Piershale Financial Group in Crystal Lake, Ill., tells Investopedia that if retirees took the pension in the form of an annuity payment, each of those payments will likely be considered taxable income. If the pension is eligible to be rolled over to an IRA, then it will be taxed when any distributions are taken from the IRA. In this case, Piershale says the retiree will owe taxes for the calendar year in which the annuity payments or distributions were received.
However, if the pension is rolled to an IRA and converted to a Roth IRA, then it will be taxed at conversion, and will apply to the calendar year in which the conversion happened, explains Piershale.
Social Security BenefitsThe retiree's total income and marital status play a role in determining if Social Security benefits are taxable. According to Ashcraft, if Social Security benefits are the retiree's only of income, they are not taxable. However, if the retiree receives income from other s, Ashcraft says retirees may have to pay taxes on their benefits.
Piershale explains that it depends on how much other income the retiree has, and is also based on how they file their taxes. From 50% to 85% of their benefits can be exposed to taxes depending on their income and whether they file a single or a joint return.
So what is considered other income? Piershale says other income includes earnings from a job, interest, and dividends. Tax-free interest is included in the calculation, so the government figured out a back door way to tax tax-free income, adds Piershale.
To determine if the benefits may be taxable, Ashcraft says retirees can use a quick calculation offered by the IRS: "Add one-half of your Social Security benefits to all your other income, including any tax-exempt interest. Next, compare this total to the base amounts below. If your total is more than the base amount for your filing status, then some of your benefits may be taxable," states the IRS's website.
According to the IRS, the three base amounts are:
$25,000 - for a single individual, a qualifying widow or widower with a dependent child or married individuals filing separately who did not live with their spouse at any time during the year
$32,000 - for married couples filing jointly
$0 - for married persons filing separately who lived together at any time during the year
Tax Bracket ChangesMost seniors make the mistake of assuming that when they retire, they'll drop into a lower tax bracket because they have less income. However, this is not always the case. For example, according to Piershale, retirees may go into a higher tax bracket when they reach age 70½ and are forced to take required minimum distributions (RMDs) from their IRAs. They have to do this by December 31 of each year or there is a nasty penalty of 50%. The first year a retiree turns 70½, he says the IRS will give them until April 1 of the following year. But after that first year, he says they will be charged the penalty if they don't comply.
However, Piershale suggests ways to avoid this. For example, they may consider Roth conversions while in a lower bracket since the taxes on converting a traditional IRA to a Roth are due in the calendar year of conversion. So, Piershale says they need to do enough conversions to fill up their lower tax bracket each year before they reach 70½.
Net Investment Income TaxPiershale also says there's a new tax that retirees should be aware of: the Net Investment Income tax of 3.8%. This is applied to the lesser of: net investment income or the excess of modified adjusted gross income (MAGI) over certain thresholds.
For single taxpayers, Piershale says the threshold is $200,000, and for joint filers, it is $250,000. And he reminds readers about the RMDs mentioned above for retirees close to age 70½. If your income is near these thresholds before you have even started taking RMDs, most likely when you do begin taking the RMDs, it will push you over the threshold, warns Piershale.
Estimating and Filing TaxesLaura Kennington, an enrolled agent at the Tax Defense Network, offers advice to help Investopedia readers avoid tax problems.
She tells Investopedia that tax issues are often the result of withdrawing a large sum of money. If you withdraw the full amount in your pension account, part or all will be taxable in the year received. To avoid a large tax bill, Kennington advises rolling the funds over into another pension plan or a traditional IRA.
If those benefits are taxable, retirees have two options. Kennington says they can pay estimated quarterly tax payments, or they can request to have those taxes withheld monthly from their pension, Social Security income, annuity, etc., by submitting one of the following forms to the organization responsible for paying the following income:
• Form W-4 for wages and military retirement pay
• Form W-4P for pensions and annuities
• Form W-4V for Social Security and railroad retirement
The Bottom LineWhen workers retire, they may encounter different rules of taxation. Increasing their level of financial literacy by understanding these rules can help retirees make the right decisions to lower their tax liability.