THE BLOG

Taxes Follow You Into Retirement

01/26/2011 05:00 pm ET | Updated May 25, 2011

Wouldn't it be nice if, after decades of hard work, scrimping and saving, you could retire and no longer have to worry about paying taxes? But that's about as likely as the Cubs winning the World Series.

Even if your income drops significantly after retirement, chances are you'll still be taxed on a portion of it. And, depending on where you choose to retire and your income sources, you'll probably also face additional taxes on everyday purchases, real estate, capital gains, inheritances -- the list goes on.

Here are a few tax-related issues to consider when budgeting for your living expenses during retirement:

Taxes on Social Security benefits. Most people can begin collecting Social Security benefits as early as age 62, although if you draw benefits before your full retirement age, your benefit amount may be reduced significantly. "Full retirement age" is 65 for those born before 1938 and gradually increases to 67 for those born in 1960 or later. (To calculate your full retirement age by birth year, click here.)

Keep in mind, however, that even though many states don't tax Social Security benefits, they are counted as taxable income by the federal government. So, depending on your overall income, you may owe federal income tax on a portion of your Social Security benefit. The formula is complicated, but basically:

  • Single people whose combined income from all sources is less than $25,000 are not taxed on their Social Security benefit. ("Combined income" is adjusted gross income plus nontaxable interest earned plus half of your Social Security benefits.)
  • For combined income between $25,000 and $34,000, you will be taxed on up to 50 percent of your benefit.
  • For income over $34,000, up to 85 percent of your benefit may be taxable.
  • For married people filing jointly: benefits are not taxable for combined income below $32,000; benefits between $34,000 and $44,000 are up to 50 percent taxable; benefits over $44,000 are up to 85 percent taxable.
  • For more details, read the IRS' Tax Topic 423 and Publication 915.

Working and Social Security. Some people find that after opting to collect a reduced Social Security benefit before full retirement age, they can't make ends meet and must go back to work. But this can backfire: If your wages are more than $14,160 a year, you will lose one dollar of Social Security benefits for every two dollars you earn over that amount. (Note: Investment income doesn't count.)

If you're scheduled to reach full retirement age during 2010, the benefit reduction will drop to $1 for each $3 you earn above $37,680 until the month you reach full retirement age. After that, there is no further reduction.

So, if you think you'll need to continue working to make ends meet, it might be wiser to hold off on collecting Social Security until you reach full retirement age. Be aware, though, that these benefit reductions are not completely lost: Your Social Security benefit will be increased upon reaching full retirement age to account for benefits withheld due to earlier earnings.

One last point about taxes and Social Security: Any wages you earn after you've begun to collect Social Security retirement benefits are subject to Social Security and Medicare taxes, regardless of your age. To learn more, read How Work Affects Your Benefits at the Social Security website.

Taxes on IRA and 401(k) withdrawals. After age 59 ½, you can start withdrawing balances from your IRA or 401(k) without paying the 10 percent early withdrawal penalty. However, don't forget that you will pay federal (and state, if applicable) income tax on the withdrawals -- unless it's a Roth plan, whose contributions have already been taxed.

Other taxes. Some people move to another state after retirement thinking they'll lower their tax burden. For example, seven states do not tax personal income (although another two do tax dividend and interest income). And five states charge no sales tax. But because property, inheritance and fuel taxes and other cost-of-living expenses vary significantly by community, you should only consider such moves after doing thorough research.

The Retirement Living Information Center features breakdowns of the various kinds of taxes seniors are likely to pay, state by state, including taxes on income, sales, fuel, property, inheritances and other items.

You may want to consult a financial planner long before retirement to make sure you fully understand all the many tax and income implications. If you don't have one, the Financial Planning Association is a good resource.

Bottom line: Be sure to include taxes among the many expenses you need to plan for at retirement.

This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation.

To participate in a free, online Financial Literacy and Education Summit on April 4, 2011, go to Practical Money Skills.