When I meet with prospective clients, one of the biggest issues raised is taxes in retirement. Obviously this is a case by case basis but there are a few generalities that can be applied. Federal workers have benefits others don't which can change a tax picture.
Once retired you will no longer be subject to "earned income" taxes including Social Security and disability (among others) taken from your paycheck. But don't let that fool you into thinking you will have no taxes in retirement. Most federal retirees definitely benefit from a reduced tax exposure but it's important to know what to expect.
Even though you are now part of the every day is Saturday club, there are still things to watch for. Currently, federal income tax rates range from 10 to 37 percent, depending on your income level and marital status. Expect to get hit with taxes on your retirement income from things like a pension, annuity, IRA, 401(k), defined benefit plan, 457, or other pre-tax retirement accounts. Monies withdrawn from qualified plans will be taxed at an ordinary income rate.
If you have money in a Roth, Roth 401(k), you will have some tax-free retirement income. While that is a great piece of a well-rounded retirement plan, few people have all of their assets in Roth accounts. If they do, they have not accumulated enough assets to fully fund a comfortable retirement. Most people will still have some income in taxable accounts, or accounts like a 401(k), which will be taxed when funds are withdrawn.
An estimated 60% of retirees will not owe federal income taxes on their Social Security benefits. That is likely why many people believe Social Security benefits are tax-free. However, they are not. What this actually means is that a majority of retired people are living on a relatively small income.
If you are in an extremely high there could be some additional taxes on Medicare. You may have heard it called the Medicare Surtax or the Obamacare Surtax. Officially, it is known as the Unearned Income Medicare Contribution Surtax. It is a 3.8% Medicare tax
that applies to income from investments and regular income above specific thresholds. For 2020, if you have Modified Adjusted Gross Income (MAGI) above $200,000 ($250,000 for married couples filing jointly), you will be subject to NIIT. I mention this because it is typically a surprise to many people when filing their taxes. It can also add up quickly, especially when people have great stock market returns and realized gains, paired with a nice income.
With proper financial planning, you will be able to replace 100% (or more) of your pre-retirement income. In many cases, it could mean paying similar amounts of taxes in retirement as you did while working. That wouldn’t be the end of the world, but it’s something you need to be aware of. Bottom line, if you do a good job saving and have a large income in retirement, you will most likely end up paying at least some income taxes on your retirement income. Good news, some amazing tax planning can help keep these tax bills to a minimum, essentially giving your retirement income stream a raise.
Matt
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