Understanding how Taxes are Calculated for Retirees
How much gross income you get in retirement and how much spendable, net-after-tax income you have in your retirement are two very different things. Most retirees like to find out how much real, after-tax income they’ll have to spend in retirement, so let’s look at a couple of examples.
There are a lot of conversations going on in the financial planning world about how to best “structure” your retirement income. By strategically combining a solid Social Security claiming strategy with smart IRA, Roth IRA, taxable brokerage, and investment grade life insurance contracts, you can tweak your retirement income to give you the highest net-after-tax income. Check it out:
Consider the example of a married 65 year old couple that has $61,130 of SS income and $15,200 IRA income. Total Income is $76,330 for the tax year 2014.
- Social Security Benefits: $61,130
- Tax-Exempt SS Benefits: ($53,630)
- Tax- Included SS Benefits: $7,500
- IRA Withdrawal: $15,200
- Adjusted Gross Income: $22,700
- Minus:
- Standard Deduction: ($14,800)
- Personal Exemptions: ($7,900)
- Taxable Income: $0
That’s right, $76,330 of income, ZERO taxes. It depends on the tax of income—here is the same $76,330, but all Social Security Income:
- Social Security Benefits: $76,330
- Excluded SS Benefits: ($73,247)
- Includible Social Security Benefits: $3,083
- Standard Deduction: ($14,800)
- Personal Exemption: ($7,900)
- Taxable Income: $0
Pretty sweet, right? $76k of Social Security benefits, all tax free because of the SS exclusion calculation, and your standard deduction and personal exemption.
How about $76,330 of 100% IRA income?
- IRA Withdrawal: $76,330
- Standard Deduction: ($14,800)
- Personal Exemption: ($7,900)
- Taxable Income: $53,630
- Total Federal Tax: $7,136
- Total State Tax: $2,483
You had $76,330 of income, and paid $7,136 of Federal Income Tax. That is an effective rate of 9.3%
Even if you add in your total Federal + State taxes of $9,619, your effective rate is 12.6%.
Social Security claiming strategies can help you combine your SS income, with IRA withdrawals and ROTH conversions to make for a fantastic retirement tax plan.
Remember, we have a marginal tax brackets in the US, so your marginal tax rate increase with the more retirement income that you have, but the effective tax rate is always lower. This is super important to understand, especially when 55 and above looking to sock as much money away for retirement as you can. Should you max out your IRA and 401(k) or pay taxes now and do a Roth account?
That is a discussion for another post, but it is good to review the 2015 tax tables, the marginal rates, and the corresponding effective rates.
| 2015 Tax Tables Married Filing Jointly > 65 | Tax Rate | Tax for the bracket | Total Tax Paid | Income for the bracket | Cumulative Total Income | Effective Tax Rate |
| Standard Deduction + Exemption | $23,100 | $23,100 | 0% | |||
| $0-$18,450 | 10% | $1,845 | $1,845 | $18,450 | $41,550 | 4.4% |
| $18,450-$74,900 | 15% | $8,467 | $10,313 | $56,450 | $98,000 | 10.5% |
| $74,901-$151,200 | 25% | $19,075 | $29,388 | $76,299 | $174,299 | 16.8% |
| $151,201-$230,450 | 28% | $22,190 | $51,578 | $79,249 | $253,548 | 20% |
| $230,451-$411,500 | 33% | $59,746 | $111,324 | $181,049 | $434,597 | 25.6% |
| $411,501-$413,200 | 35% | $595 | $113,025 | $1,699 | $436,296 | 25.9% |
| Over $413,201 | 39.6% | TBD | TBD | TBD | TBD | TBD |
Study this tax table for a little bit, and understand the significance of it. The standard Married Filing Jointly tax brackets are on the left. I’ve added up the standard deduction ($12,600 + $2,500 > 65) and personal exemptions ($8,000) figures for this married couple as well. This means that without any Social Security, the 1st $23,100 of income is tax free!
If you withdrew $98,000 of income from your IRA pre 70.5, it is taxed at an effective rate of 10.5%! The RMD factor period for a 70 year old is 27.4. If you have a $100,000 IRA, your RMD would be $3,650 ($100,000/27.4) or 3.6%.
If 3.6% of your IRA is $98,000, then it would have a value of $2.72 million. What kind of income does it take to get to $2.72 million if you’re putting 10% of your income into an IRA each year for the next 30 years and earning 10%? About $165,000/year- this means that your 401(k) /IRA contribution would be taxed at 28% per year (the marginal tax rate for $165,000 income bracket) if you weren’t getting the qualified plan deduction. Getting a 28% tax deduction on your IRA/401(k) contribution and paying 10.5% tax on your withdrawal is a winning combination!
The tax on your IRA could be higher if you have other taxable income like Social Security, but even if you get $30k (maximum of 85% taxable) of that $98,000 from Social Security, you will still only have an effective tax rate of 14% on the IRA, less than the 28% you saved as a deduction when you made the contribution.
What about the IRA early 59 ½ penalty? Well, how many people are really going to retire before 59 ½ anyways? And if you have a good reason to take the money out, like medical issues, disability, college education, house down payment, or early retirement, (using the SEPP rule – Substantially Equal Periodic Payments, minimum of five years or age 59.5 whichever comes last) you can get around the 10% penalty.
Roth withdrawals are 100% tax free, and they don’t count towards your Social Security taxes or Medicare penalty fees. Same thing for investment-grade life insurance, but you should only do that if you’ve maxed out your IRA, and Roth account options, including the Back Door Roth strategy.
I hope this little review helps, for those of you that are serious about looking at putting together a smart tax optimization plan for your retirement, call my office or email me dave@anthonycap.com, and we’ll take 15 minutes to review your situation and what options you have.
Paying taxes in retirement is a choice! With proper tax planning and investment management you can avoid a lot of the silly tax issues that most retirees complain about—be smart and get a plan!
Dave Anthony, CFP® 