Can You Predict Your Income Taxes in Retirement?

Carrie Schwab Pomerantz
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Posted: Sep 13, 2012 12:01 AM

Dear Carrie: I'm hoping to retire in the next couple of years. I'm starting to plan my budget and I am wondering how much I'll have to pay in income taxes. Can you help? --A Reader

Dear Reader: With future tax rates up in the air, it's pretty near impossible to accurately predict what any of us will be paying in income taxes in the future. But while your tax rate may be uncertain, understanding how different types of income are taxed can help you get a good sense of your ultimate bill. Thinking about the individual parts can also help you make tax-smart decisions when it comes time to draw from your various retirement income sources.

Review Your Sources of Retirement Income
    Start by reviewing this list of common sources of retirement income and how withdrawals are taxed:
    --Traditional IRA, 401(k), 403(b) or other employer-sponsored plan. If contributions were made with pre-tax dollars, ordinary income tax rates apply.
    --Roth IRA and Roth 401(k). Both contributions and earnings are income tax-free once you reach age 59 1/2 and you've held the account for five years.
    --Nondeductible IRA. Contributions are made with after-tax dollars. So while you pay ordinary income taxes on earnings, withdrawals of contributions are tax free.
    -- Pension. If all contributions were made with pre-tax dollars, withdrawals are treated as ordinary income.
    --Annuity. It depends on the type of annuity. For immediate annuities, a portion of each payment is considered a return of principal and a portion is considered interest. The interest portion is taxed as ordinary income. Likewise, interest from deferred annuities is treated as ordinary income. It's best to talk to your tax advisor.
    -- Investment income. Capital gains rates apply. Gains on short-term investments (held for less than a year) are taxed as ordinary income. Gains on long-term investments (held for one year or more) are currently taxed at 15 percent (or 0 percent if you're in the 10 to 15 percent bracket).
    --Social Security. Depending on your total income, 50 to 85 percent of your benefits may be taxed as ordinary income.
    -- Reverse mortgage. The income is tax-free.

Now divide your own sources of income into those that are subject to ordinary income taxes and those that offer some tax benefits.

Consider Your Withdrawal Strategy

With your sources of income in mind, you can begin to plan a withdrawal strategy. Because you're starting to budget, you've probably estimated your retirement expenses. How will you cover them?

From a tax perspective, it's usually better to sell long-term investments held in taxable accounts and pay taxes at the lower long-term capital gains rate before taking money from tax-deferred accounts that is taxed as ordinary income. An added benefit is that, if you sell at a loss, you can use up to $3,000 to offset gains and carry additional loss forward.

Another approach is to withdraw only the amount from retirement accounts that will keep you in a lower tax bracket -- for instance, the current 15 percent bracket. (For 2012, that's $70,700 for married filing jointly; $35,350 for single filers.) Then make up any shortfall from your taxable accounts. 

If using this approach, remember that Social Security is part of your total income. When you start to take benefits, you may need to adjust your withdrawals to make sure you're not kicked up into a higher bracket.

Another caveat is that, once you reach age 70 1/2, you'll want to be certain to take your Required Minimum Distribution (RMD) from each tax-deferred account before applying any other strategies. There's a significant penalty for failing to take your RMD.

Keep These Tax Advantages in Mind
    As you plan ahead, you should be aware of two tax situations that can work to your advantage:
    -- Company stock in a 401(k). If you transfer your company stock to a taxable account, you'll pay ordinary income taxes only on the cost basis of the stock (the average cost at the time you received it from your employer). This could be significantly lower than the current value. If you sell immediately, you pay long-term capital gains taxes on the appreciation beyond the cost basis. If you wait to sell, you'll pay taxes on any additional appreciation at either the long- or short-term capital gains rate, depending on your holding period.
    -- Sale of your home. Gain on the sale of your home can be tax-free if it's less than $250,000 for a singe filer or $500,000 for a couple as long as you meet certain IRS requirements.

With all the variables, there's no easy formula for calculating your income taxes in advance. But a little planning can go a long way in helping to control your tax burden. This would be a good time to talk to your tax advisor and plan a strategy. The more money you can keep in your pocket, the better!

Carrie Schwab-Pomerantz, CERTIFIED FINANCIAL PLANNER(tm), is president of Charles Schwab Foundation and author of "It Pays to Talk." You can email Carrie at askcarrie@schwab.com. This column is no substitute for an individualized recommendation, tax, legal or personalized investment advice. To find out more about Carrie Schwab-Pomerantz and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate website at www.creators.com.
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