Navigating Taxes in Retirement

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The tax landscape shifts suddenly when most Americans leave the labor force to retire.  The single most important thing to remember is that income taxes can fall dramatically, because retirement incomes are typically lower and because all or a portion of your Social Security benefits will be tax-exempt.

Vorris J. Blankenship photo
Vorris J. Blankenship

This was among the tax insights supplied by Vorris J. Blankenship, a retirement tax planner near Sacramento, California, who has just finished the 2015 edition of his 5-inch thick “Tax Planning for Retirees.”   The following is an edited version of tax information he supplied to Squared Away:

Lower taxes in retirement. Brian and Janet are a hypothetical couple renting an apartment in Nevada, a state with no income tax. In 2013, Brian earned $40,000 at his job, and Janet’s wages were $20,000, for a total income of $60,000. They took the standard deduction on their federal tax return and paid income tax of $5,111.

Brian retired on December 31, 2013. In 2014, he received Social Security payments of $15,000 – $2,750 of which was taxable – and a fully taxable pension from his former employer of $10,000. About one-third of retirees pay some income taxes on their Social Security benefits, because their retirement income exceeds certain thresholds in the tax code.

In 2014, Janet again earned $20,000, but the couple’s total household income declined to $45,000 from $60,000. They took the standard deduction on their federal tax return and paid income tax of only $1,248.

The 75 percent reduction in their taxes is much larger than the 25 percent decline in their income after Brian retired.

Control your 401(k) or IRA withdrawals. Some retirees take a lump sum distribution of all the funds in their IRA or 401(k). Doing so pushes their taxable income temporarily into a much higher tax bracket, sacrificing financial assets they may need as they age. A slow, judicious withdrawal of funds over many years in retirement not only prevents a large, one-time tax hit. It also preserves retirement savings while allowing investment income to continue accumulating tax-free, both of which provide more long-term financial security.

Assume our hypothetical retiree, Brian, had $150,000 in a 401(k) that he unwisely liquidated when he left his employer. He made no additional contributions to the plan so the entire $150,000 withdrawal is taxable. Brian and Janet’s total income for 2014 – Brian’s first year in retirement – balloons from $45,000 to $195,000, pushing them into a much higher income tax bracket with a 28 percent top marginal tax rate, compared with 10 percent if he had not liquidated the 401(k).

The widow(er)’s tax break. Federal tax law requires individuals who reach age 70½ to begin taking required minimum distributions (RMDs) from their 401(k)s or IRAs, triggering tax payments on the amount withdrawn. In the initial years, the RMDs are a small percentage of a retiree’s total retirement savings balance, but this percentage increases with age.

When the retiree with the tax-exempt plan dies, the spouse who inherits the balance in those accounts can roll them over to an IRA in her own name.   Surviving spouses are often younger, which means they can avoid the RMD altogether – if they’re still under 70 ½.  If they’re over 70 ½, they will face a lower RMD percentage on the inherited assets, because they’re younger than their former spouse.  In either case, the tax bite will be smaller, if the assets were rolled over to the survivor’s new plan.

The Roth IRA advantage. It may make sense for some well-heeled retirees to roll over some funds from a traditional IRA to a Roth IRA.  The primary advantage of a Roth IRA is the ability to pay for nursing home or other large expenditures down the road without incurring the high marginal tax rates that withdrawing large amounts from a traditional IRA would trigger. In a Roth IRA, a retiree can withdraw money, including the investment income, totally tax-free if he has had the Roth IRA for more than five years.

Since the funds being withdrawn from a traditional retirement account are taxable, a gradual rollover will minimize the taxes paid each year. Timing is also critical.  The lower tax rate that often comes immediately after retiring may provide the best opportunity to fund a Roth IRA – before the RMDs have started.  Under tax law, any taxes triggered by a rollover would be in addition to the RMD taxes.

Mark Zoril

Nice. Over the years, I have heard many of my clients say, literally, that “they make more money in retirement than while they were working.” My Father said the same thing. And I work with middle class people. The situation is that for most people, it is not that they actually make more, it is, in many cases, they simply take home more. They no longer pay FICA (unless they have earned income), their overall tax burden is lower, and they no longer need to save for retirement. This can represent a lot of money. Obviously this does not apply to everyone, but it does for many. I tell my clients if they end up in a higher bracket and pay more money in taxes in retirement, congratulations!

Paul Brustowicz (@PaulBrustowicz)

I have made similar comments before about taxes in retirement.
I retired in 2011. My 1040 for 2014 will report income from Social Security for my wife and me, pension income from former employer, minimum required distribution from my IRA and qualified annuity income from an IRA transfer.

TurboTax says it makes no sense to itemize deductions since I am mortgage free and live in a low property tax state. I take the standard deduction. I owe Uncle Sam about $13K.

Everyone talks about saving in tax-deferred products for retirement when you’ll be in a lower tax bracket. I am paying more now than I ever did thanks to saving/investing in 401(k)s and IRAs. Who knew the trade-off of tax deductible contributions and tax-free growth during working years would throw me into higher tax bracket?

I am not complaining. I am happy to have the retirement income and live a comfortable life style.
My advice to workers is use Roth retirement accounts, pay the tax upfront and invest wisely.

Joel Frank

An IRA is a tax-deferred plan, not a tax exempt plan.

Dave G.

Re: “The 75 percent reduction in their taxes is much larger than the 25 percent decline in their income after Brian retired.”

OK, but the couple’s net income is still over $10,000 less. So they clearly had a much larger decline in income than the decline in their taxes after Brian retired. It’s what left in their pocket that counts.


I’ve been retired just over a year, and have just made my 1st withdrawal from one of my traditional IRAs. Rolling some of my federal TSP (traditional) to the Roth side appeals to me. I’d love to see a tool (spreadsheet, etc) that would allow me to input my balance, projected annual withdrawals for living expenses, and how much I could roll to the Roth without triggering a higher tax bracket.

Any thoughts?

J Ross

Clarification for the Federal tax law for RMD from your 401(K)/IRA: You must take a RMD from your 401K or IRA if you are age 70 1/2 AND retired. If you are still working, you do not need to take the RMD when you reach age 70 1/2.

Juanita Barnett

As a single, divorced woman who just turned age 70, I plan to retire from the Federal government at the end of November 2015. I am considering having a small home built (6 months delivery schedule) in an age 55+ community nearby. In order to have sufficient funds for a down payment and keep my monthly expenses low after retirement, I plan to withdraw approximately half of my TSP savings for this purpose. Should I contract for this house to be built in June before retirement, or should I retire first, then withdraw the funds? Am thinking about tax repercussions!

Kurt Andolsun

It’s true that a lot of people clear more in retirement than while working, not to mention a significant drop in expenses associated with work (i.e. lunches, clothes, transportation, more break downs/expenses on cars, etc). My income in the last year I worked was a gross of $180,000 and my retirement income is $123,032. The great thing is that I clear over $1,200 a month more now then while working, and save about $750 in expenses related to working. Besides the items you mentioned, another big saver is not all of my pension is taxable as I previously was taxed on the contributions to my retirement account (not IRA). This is another deduction of about 7.5%. On the negative side, what reduces my taxable income is that my medical expenses have gone up as my health is not quite as good as before, but at least I can afford my expenses much more easier today than when I was working.

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