Once you retire from federal service, you face new tax issues. This could affect whether you change tax brackets or not. Retirement generally means lower income, so that means lower taxes, right? Maybe. But retirement can also mean multiple sources of income, which can complicate tax payments. You may have Social Security income, distribution income from retirement accounts, military retired pay, and/or income from investments, property, part-time work, etc.
Each one of these comes with its’ own set of tax rules.
When the Social Security Act was passed, these benefits were never intended to be a primary source of retirement income. According to the Social Security Administration, today payments replace approximately 40 percent of pre-retirement wages for retirees. Initially, Social Security payments weren’t subject to taxes. That’s no longer the case. Those who rely primarily on Social Security to pay their bills to escape taxation, because their overall income is too low.
However, for the high-income recipients, 15 percent of benefits are tax-free and 85 percent are taxed. The amount that is taxable depends on how much income you have in addition to Social Security. Another thing of note regarding Social Security is where you live. This determines how your benefits are taxed at the state level. There are 28 states, and Washington, D.C., that don’t tax Social Security income.
IRA and 401K Withdrawals
Except for Roth IRA withdrawals, all other income from retirement accounts is taxed in some way. Once you reach age 70 ½, you are required to start withdrawing money from your retirement accounts each year. This includes IRA’s, 401k, 403(b), and 457 plans. The government requires you to take a Required Minimum Distribution (RMD) so it can collect taxes on this income.
The IRS imposes a 50 percent tax penalty on amounts that aren’t properly disbursed from your 401k account. The amount of tax you pay depends on the total amount of income and deductions you have and what tax bracket you’re in for that year.
Roth IRA disbursements aren’t taxed because those contributions are taxed when they are deposited into the retirement account. To withdraw tax-free, you must wait until age 59 ½. These accounts don’t have a required distribution, so you can let the money grow tax-free your whole life.
Benefits from pensions and annuities are taxed. If the money went into your fund, by you or your employer, before it was taxed, it will be taxed when you withdraw it. Most pension accounts are funded with pre-tax income, which means the entire amount of your annual pension income is included in your taxable income each year.
Tax rules for annuities purchased with after-tax dollars are determined by the type of annuity you own.
- Immediate annuities—payments from an immediate annuity include principal, as well as the interest-only interest portion. Both are considered taxable income.
- Fixed and variable deferred annuities—If you put money in a fixed/variable deferred annuity, you don’t pay taxes on the gain in the annuity until you take withdrawals. If you take withdrawals before age 59 ½, any gain withdrawn is taxed at your ordinary income tax rate and is subject to a 10 percent penalty tax.
If your annuity is owned by an IRA or another retirement account, then the tax rules of those retirement accounts apply to any withdrawal or annuity payments you receive from that annuity.
Other Taxable Retirement Income
Other income accrued during retirement is also taxed. Interest income, dividends, and capital gains on investments will be taxed just as they were before you retired.
However, not all retirement income is taxed. If you own a bank CD, and it matures, that extra money isn’t considered taxable income. Only the interest it earned must be reported.
The main thing to remember is your tax rate in retirement depends on your total amount of income and deductions.
If you are a federal employee struggling with a disability and looking to retire now, you may be eligible for Federal Disability Retirement! This benefit provides a monthly income until you reach age 62 where your Federal Disability Retirement will automatically transfer into your regular FERS pension. Schedule a FREE consultation with our firm to learn more.