Retirement & Taxation

Retirement income is not always exempt from federal taxation.

During retirement, people are subject to complex tax rules that apply to all sources of income, including government Social Security distributions. While some seniors experience zero tax liability and don't have to file yearly taxes, others may be subject to steep taxes on a lifetime of capital gains and deferred-tax contributions.

Social Security

Retirees typically generate income from multiple sources, including Social Security. Over a person's working life, he pays Social Security taxes based on income. Upon reaching retirement age, he can file for monthly Social Security benefits. Retirees who live only on Social Security are not liable for taxes on that income. However, if a person receives Social Security benefits in addition to income from other sources, such as pensions, annuities and other retirement plans, part of the Social Security benefits may be taxable. Depending on the retiree's annual income and tax filing status, up to 85 percent on Social Security benefits may be taxed.

Tax-Free Distributions

Some retirement accounts pay out distributions with zero tax liability at retirement. For example, a Roth IRA offers no tax benefits for contributions. However, once the account reaches maturity, a retiree can make withdrawals on both the principal contributions and all capital gains in the account without paying any taxes. To take advantage of the zero tax liability, the account holder must have opened the account at least five years prior to making a withdrawal, and he also must be at least age 59 1/2. Any withdrawals made prior to this age are taxable and subject to early withdrawal penalties.

Other Retirement Income

Traditional IRA accounts as well as 401k distributions and other retirement accounts are usually fully taxable upon maturation. These accounts typically offer tax-deductible benefits when contributions are made, making all balances inside the accounts taxable. Money inside these accounts is not taxed until it is withdrawn, making it beneficial for retirees to delay withdrawals to control their yearly tax liability. However, many retirement accounts have minimum distribution requirements (MDRs) that determine a minimum amount that a retiree must withdraw each month after reaching a certain age--usually 70 1/2.

Estate Planning

For retirees planning to leave a substantial amount of money or assets to heirs, relatives or other beneficiaries, proper estate planning is essential to avoid expensive taxes. Congress sets estate taxes and changes the rules on a regular basis. A retiree can avoid estate taxes by giving heirs an early inheritance of up to $13,000 per year. Any amount given up to this dollar amount is not subject to the estate tax or the gift tax. Alternatively, a retiree can will an unlimited amount of money and assets to a surviving spouse with zero tax liability.

References

• IRS: Seven Facts About Social Security Benefits
• Fairmark: Roth IRA 101
• IRS: Retirement Plans FAQs regarding Required MInimum Distributions
• CNN Money: Money 101 - Lesson 21