Tax Transitions: From Employment to Retirement

As you approach retirement, it’s crucial to gain a clear understanding of how your tax situation is about to undergo a significant transformation. Transitioning from the realm of working as a W2 employee to retirement brings a new set of tax considerations. In this blog post, we’ll explore how taxes evolve, moving from federal income taxes, FICA taxes (Social Security and Medicare taxes), and state and local taxes during your working years to a new landscape involving retirement account withdrawals, pension income, and Social Security benefits.

Taxes During Your Working Years:

Throughout your working years, taxes have played a significant role in your financial life. Here’s a breakdown of how federal, FICA (Social Security and Medicare), and state and local taxes work during working years (for those who are W2 employees).

1. Federal Taxes:

   Federal income tax generally accounts for the majority of your tax obligations as a working individual. It’s a progressive tax, meaning your tax rate increases with your income. The tax rates span from 10% to 37%, depending on your earnings. You have the option of taking either the standard deduction or itemizing deductions when calculating your final tax obligation for a given year. The standard deduction is a fixed amount that reduces your taxable income (currently $13,850 is single / $27,700 if married), while itemizing deductions enable you to list specific expenses (e.g., mortgage interest, medical costs, charitable contributions) to potentially lower your taxable income further. The choice between the standard deduction and itemizing hinges on your individual financial circumstances. In general, you only elect to itemize deductions if the grand total of these deductions exceeds the standard deduction.

Here are the 2023 tax tables:

2. FICA Taxes (Social Security and Medicare Taxes):

   Social Security tax, set at 6.2%, helps fund programs that provide financial support to eligible individuals, including retirees, disabled individuals. For 2023, this tax applies to the first $160,200 of your earnings. This means that if your annual income exceeds this threshold, you won’t pay the 6.2% tax on earnings beyond $160,200. Your employer matches this tax, resulting in a total contribution of 12.4%. For Medicare tax, there is no income cap, and you’ll pay a fixed rate of 1.45% (and your employer matches this for a total tax of 2.9%).

3. State and Local Taxes:

   Each state has its own tax system, with varying rates and rules. Some states impose income taxes, while others have no state income tax at all. State and local taxes can significantly impact your overall tax liability, making it essential to consider your state of residence when planning your finances. States may also offer their own set of deductions and credits, which can further affect your tax situation.

Taxes for Retirees:

Now, as you prepare to transition into retirement, let’s explore how your tax landscape changes:

1. Distributions from Qualified Retirement Accounts:

   One of your primary sources of retirement income may be withdrawals from qualified retirement accounts, such as 401(k)s and IRAs. These withdrawals are typically taxed as ordinary income at the federal level. The tax rate you face depends on your total taxable income, which now includes Social Security benefits, pension income, and other sources. If you contributed to a traditional 401(k) or IRA with pre-tax dollars during your working years, you’ll owe federal income tax when you withdraw funds in retirement.

At the state level, the taxation of retirement account withdrawals varies by state. Some states may fully or partially exempt retirement income from taxation, while others follow federal rules. It’s crucial to understand your state’s specific regulations to manage your tax liability effectively.

2. Pension Income:

   Pension income is typically taxed as ordinary income at the federal level. The tax treatment varies based on factors such as whether you or your employer contributed to the pension plan and whether your contributions were made with pre-tax or after-tax dollars.

Similarly, at the state level, the taxation of pension income varies widely. Some states fully exempt pension income from taxation, while others tax it based on certain criteria. Knowing your state’s rules is essential to plan your retirement finances.

3. Social Security Benefits:

   Social Security benefits can be a significant source of income in retirement. The portion of your benefits subject to federal income tax depends on your combined income, which includes your adjusted gross income, nontaxable interest, and half of your Social Security benefits. For 2023, if your income is between $25,000 – $34,000, up to 50% of your Social Security benefits may be taxable. If income is above $34,000, up to 85% of your benefits may be taxable.

State taxation of Social Security benefits varies considerably. Some states fully exempt Social Security benefits from taxation, while others tax them partially or follow federal guidelines. Understanding your state’s rules is crucial for accurate tax planning.

It’s crucial to remember that while federal taxation on retirement income sources follows a standard set of rules, states have their own specific regulations for taxing retirement income. Some states may offer additional deductions or credits, further affecting your tax situation. Therefore, consulting with a financial advisor who is well-versed in both federal and state tax laws is highly recommended to ensure a comprehensive and efficient retirement income strategy.

Example:

Now let’s look at a hypothetical example assuming the following:

1. During working years, joint household income is $300,000 per year before taxes.
2. Each spouse maxes out their Roth 401(k) elective deferral at $22,500.
3. They take the standard deduction and file a joint tax return.
4. The family lives in Pennsylvania, which imposes a 3.07% tax.
5. Local taxes are 2%.
6. For simplicity, no credits, or deductions (outside of the standard deduction) are factored into this breakdown.

Now let’s look at the same couple, but assuming they are retired with the following streams of income:

1. Social Security totals $80,000 (total between both spouses).
2. They receive $50,000 per year in pension income.
3. They pull $50,000 from their Traditional IRAs.
4. Lastly, same as above, they claim the standard deduction and file a joint tax return.
5. For simplicity, no credits, or deductions (outside of the standard deduction) are factored into this breakdown.

Although the gross income during working years is $100,000 higher vs income during retirement, the net monthly income is almost exactly the same since Social Security, Medicare, and local taxes do not apply to retirement income sources.

Understand How Your Tax Situation Changes

As you approach retirement, it’s vital to have a solid understanding of how your tax situation will change. The transition from being an employee subject to federal, FICA, and state and local taxes to a retiree managing distributions, pension income, and Social Security benefits requires careful planning. Furthermore, the unique tax rules of each state add another layer of complexity to your retirement tax considerations.

To ensure you make the most of your retirement savings and minimize your tax liability, it’s advisable to work closely with a financial / tax advisor who can provide personalized guidance. By doing so, you can navigate these changes with confidence, ensuring that your retirement nest egg remains as tax efficient as possible, allowing you to enjoy your hard-earned retirement years to the fullest.