Income Taxes Follow Participants Into Retirement

Near-retirees broadly worry about future health care costs, the impact of inflation and market downturns—but relatively few are tackling the subject of income taxes in retirement.

As more American workers are expecting to rely on defined contribution (DC) plans and individual retirement accounts (IRAs) to fund their retirement years, concerns are growing about how to best manage lifetime income streams.

As part of this effort, according to Daniel D’Ordine, founder of DDO Advisory Services, late- and even mid-career retirement savers should start doing a lot more advanced planning about minimizing income taxes in retirement. Depending on where they live and how they structure their retirement income, retirement savers may find themselves paying unexpectedly high amounts of taxes each year to both the federal and state governments, D’Ordine warns.

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Should an individual’s retirement income stream stem mostly from Social Security, it would be unlikely for the retiree to pay a great deal of income taxes, D’Ordine says. However, if the individual has accumulated other significant sources of income, such as a 401(k) or defined benefit (DB) plan, then taxes will be assessed on what is commonly described as “combined income.” Depending on how the public and private sources of income are structured, the federal government can assess taxes on up to 85% of Social Security benefits, contingent on combined income and other factors, such as marital status. 

At the state level, taxes on retirement income will also vary considering the participant’s sources of annual income. Currently, 13 states issue their own taxes on Social Security. These are Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, and West Virginia. Based on the source of income and the state’s legislation, DC and DB plan participants can also expect to pay (or be exempted from) taxes on military retirement income or pension income. Northern states are known to have higher property, income and sales taxes, generally speaking, D’Ordine adds.  

“Generally speaking, states in the south tend to have lower taxes than states in the north. That’s why a lot of people like to move to Florida—there is no income tax there,” notes Sandra Block, senior editor at Kiplinger. Of course, retirees shouldn’t have to move unless desired. If employees understand the tax obligations they will face throughout retirement and appropriately respond, moving between states can be a choice, not a necessity.

Diversifying to minimize tax obligations

There are many planning opportunities to take advantage of today from a tax-optimization perspective, even for those in their 20s, 30s and 40s, the experts agree.

The first step to mitigating future tax expenses, according to Angie O’Leary, head of wealth planning at RBC Wealth Management, is to consider diversification with respect to account types and their prospective tax requirements. Employers, for their part, can establish a Roth IRA option.

“There are strategies of rolling some amount of traditional 401(k) dollars over into a Roth IRA that are potentially advantageous, especially if you have a couple of years where your income is lower,” O’Leary explains. “Having tax diversification available down the line is really helpful in building that paycheck in retirement.”

According to D’Ordine, participants often have questions about the tax burden associated with annuities. Those who buy a lifetime annuity with a lump sum of money are guaranteed to receive a set, predictable payment throughout retirement, but how will this be taxed?

“Annuities add some security and take a bit of the pressure off,” D’Ordine says. “Much of the monthly payment in this case will be considered return of premium, but the rest of it will be taxable. There is a lot to consider.”

For participants retiring earlier on, who may need additional income before claiming Social Security benefits, D’Ordine mentions the possibility of purchasing a limited term annuity, say five years, where a majority of the money received monthly is considered return of premium.

A lot of people don’t understand annuities. A lot of people buy them to guarantee income in retirement, but how those are taxed depends on how you bought them,” Block warns. “If you bought them with after-tax income, you’ll only pay taxes on the annuity earnings, but if you bought an annuity with your money from an IRA that has not been taxed, then all of the annuity payouts are probably going to be taxable.”

Also notable is that health savings accounts (HSAs) provide a triple-tax benefit for participants, according to O’Leary. When available, HSAs can and should be used in concert with other accounts to minimize overall tax burdens. “You put in the tax dollars, it grows tax-deferred, and if you use it for medical expenses it’s tax-free,” she says.  

Plan sponsors can help

Among the list of more straightforward tactics plan sponsors can implement to address retirement income taxation is to introduce targeted education programming and encourage DC plan participants to explore their options both in-plan and out-of-plan, O’Leary and D’Ordine agree.

One-on-one reviews with a financial adviser, D’Ordine says, can be crucially beneficial to participants unaware of the tax implications of their retirement income planning.

“Creating the regular paycheck in retirement is a moving target,” O’Leary notes. “Having plan sponsors think through this challenge and help educate participants around the taxability of their portfolios is so important. Before, it used to just be about your pension and Social Security, but now there’s just a lot more to manage.”