Dealing with Retirement Taxes - dummies

By Lita Epstein

Everyone hates to pay taxes. Unfortunately, you do still have to pay them in retirement. Both your pensions and some of your retirement savings are taxed by the government, but exactly when, how, and if these are taxed hinges on a number of decisions that you make about your retirement investments.

Taxation of your pensions

Taxation of your pension payout is usually done for you by your company, just as taxes were taken out of your paycheck while you were working. Most pensions are taxed based on your current income tax rates. You likely will fill out a form (or may already have done so) indicating whether to take out taxes when you pick your pension payout method.

After your first year of receiving your pension payout, work with your tax advisor to be sure the proper amount is being taken out of your pension. If not, you can file a form to change the amount of tax you pay. But, you probably are better off paying any additional taxes needed by filing quarterly estimated tax forms and paying any additional taxes that way.

Paying estimated taxes quarterly gives you more control over any changes you may need as you move through the various phases of retirement and your tax deductions change. As you complete your taxes each year, do an estimation of your income for the next year and recalculate any estimated taxes you might need to pay.

Most tax advisors do this automatically as part of your income tax preparation without any additional charge. If you use a tax preparation package and prepare your own taxes, most tax preparation software for your home computer also will automatically calculate payments for the next year’s quarterly estimated taxes.

Taxation of your retirement savings

Taxation of your retirement savings is much more complicated because whether you’re taxed depends on the type of retirement savings account you have. Keep these factors in mind and talk to a tax professional to assess your needs:

  • Most of your accounts will be taxed based on your current income tax rate. This includes money you withdraw from your traditional IRAs, your 401(k)s, your 403(b)s, and most other employer retirement savings plans. This will change each year depending on how much income you draw from your IRAs, how much you are paid through a pension or annuity, as well as any other income you receive including income you earn working full- or part-time in retirement.
  • If you are old enough to collect Social Security, that adds another complication to the mix.
  • The one exception to the rule in the previous bullet is any funds you withdraw from a Roth IRA. Money you take out of a Roth IRA will not be taxed as long as you start taking it out after you reach age 59-1/2.
    Another big advantage of the Roth IRA is that you are not forced to take your money out at any time. You can decide to leave all your money in a Roth IRA to your heirs if you so choose.
  • You will have to take out mandatory distributions of all your other retirement savings If you fail to take out enough to meet the IRS mandatory distribution requirements, you will be taxed 50 percent of any shortfall.