Responsible retirement planning begins early in a career. As time goes by, money placed in an IRA or a 401(k) will grow, allowing for a comfortable retirement.
But post-retirement, the money saved over decades undergoes a fundamental change. Most retirement accounts allow money to be invested before taxes, such as when a company places pre-tax income into a 401(k) account. After retirement, however, all of this money is subject to income tax.
[See 12 Low-Tax States to Retire.]
Many retirees aren't aware of the tax implications of their retirement savings, and don't include taxes in their spending plans. U.S. News recently spoke with two retirement experts about what retirees can expect when their working days are done.
What changes after retirement?
Karen Reed, director of communications at TaxResources, Inc., says the most common change for retirees is a change in income bracket. Fixed-income payments are often less than regular salaries.
"For most average taxpayers, income drops and they move into a lower tax bracket," Reed says. "When a person is on a fixed income made up only of retirement plan distributions and Social Security, a tax return still needs to be filed unless the income is below the IRS annual filing threshold."
This change in income status also means that many retirees will not be able to claim many of the deductions they have in the past, says David Du Val, vice president of tax services at TaxResources.
"They will not have the common business deductions they had while actively working, but the income would still generate taxes," Du Val says.
The source of retirement income also has tax implications. Du Val says retirees who are living off capital gains from investments in stocks and other instruments could benefit from lower tax rates.
Are there tax disadvantages to being retired?
Reed says the main disadvantage and a common misconception among retirees is that pre-tax income saved over a career does not remain tax-free in retirement. She warns that the IRS could impose stiff penalties if taxes aren't paid on this income.
"Taxpayers who have contributed pre-tax money to their retirement accounts often do not realize that they are required to pay taxes on the distributions, and when income is above certain limits, up to 85 percent of Social Security income is also currently taxed," Reed says.
Are there tax advantages in retirement?
Reed says the two primary advantages are a decrease in income tax for many, and the ability to withdraw money from retirement accounts without penalty.
"There's a slightly higher standard deduction for taxpayers over 65. Many retired people pay less in taxes due to the lower tax brackets they may find themselves in now, Reed says. "Taxpayers over the age of 59 1/2 generally have full access to their retirement funds—they are no longer subject to the penalties for early distribution."
When should investors start planning for retirement taxes?
Planning for taxes in retirement should start early and continue over the course of a career, Du Val says. "People should start in their 20' and 30s," he says. "Young people have time on their side and can start now and turn Roth IRAs and Roth 401(k) plans into hundreds of thousands of dollars, and all tax-free when they retire."
As workers enter their 50s, Reed says, they should start earmarking funds that will be used to pay taxes when they leave the workforce.
"For many taxpayers, the goal is to make their investments stretch as long as possible," Reed says. "When this is the case, it is helpful to make a projection of the income needed to meet expected living expenses as compared with the anticipated account balances at retirement age and how much annual income the accounts will be able to provide."
"If your accounts are falling short of your future needs, prepare for your future retirement by contributing as much as possible to your retirement plans now," she adds. "Individuals who are 50 or older are allowed to make additional 'catch-up' contributions, ranging from $1,000 to $5,500, depending on the type of plan."