You’ve enjoyed your first year of retirement, more time with your spouse and grandchildren, some travel, and time to invest in some hobbies you’ve wanted to get to. But the mundane responsibilities of life still claim some of your attention. You mow the lawn, pull the weeds from the garden, shop for groceries, and get your taxes filed. You’ve always done your own taxes because you want to stay on top of your money.
You gather all your documents and begin the process. After inputting all the data, you get to the bottom line and realize you owe. This never happened during your working life. Your withholding always covered your tax burden and left you with a tidy refund. You rerun the numbers looking for mistakes you might have made but still get the same result. You ask “What happened, why do I owe?” Welcome to the retirement tax trap.
Your assumption was that since you were no longer working, your income would be far less and your taxes would be lower. But that’s not what you are seeing. This retirement tax trap has many contributing factors.
- Withdrawal from IRAs, 401Ks, 403(b)s, 457s, SEP IRAs, and Simple IRAs, are treated as income and taxed at your marginal income tax rate.
- Up to 85% of Social Security payments are taxable as income.
- Interest and dividends are treated as income and taxed at the marginal tax rate.
- Capital gains from investment accounts are taxed at lower rates (0%, 15%, or 20% depending on your income) but are still taxed.
- While the sale of your primary residence may have an exclusion ($250,000 for single filers, $500,000 for couples), the profit of the house sale may be more than the exclusion and this excess is taxable as a capital gain.
- Money you receive from a rental property is part of your income.
- Pension income is sometimes taxable.
- Widows and Widowers have moved from joint filers to single filers and the tax rates are higher for single filers.
There are strategies to help lower the tax burden in retirement and avoid the retirement tax trap, but it takes proper planning. Steps can be taken before and during retirement. Perhaps today is a good day to contact your financial advisor to work on avoiding the retirement tax trap.