Tax Planning
Once you’re fully retired, your taxable retirement income streams will generally fall into one of two categories: Steady and Variable.
Steady Retirement Income Streams
Steady Retirement Income Streams are those income streams for which you receive the same amount each month. These include Social Security benefits and most retirement plan distributions. Yes, you can set up your retirement plan distributions to be paid to you quarterly or even annually, but the same logic applies.
Variable Retirement Income Streams
Variable Retirement Income Streams are those income streams that will vary throughout the year. These include interest, dividends and capital gains distributions, and short-term and long-term capital gains income received on your investment portfolio. Most people do not have Federal or State income taxes withheld from any of these variable retirement income streams.
If your taxable income is more than $50,000 annually, you should consider having Federal income tax withheld from your steady retirement income streams in order to avoid a large, unpleasant income tax bill when your return is e-filed the following April.
Up to 85% of the Social Security benefits that you receive are taxable income to you. The exact percentage will be determined by your Adjusted Gross Income (AGI) as reported on your Federal Form 1040 income tax return each calendar year. Contact the Social Security Administration at https://www.ssa.gov to request that they withhold 10% from your monthly benefits for Federal income tax.
Similarly, you should contact each fiduciary of your retirement plan accounts to request that they withhold 10% (maybe 12% if your AGI is higher) from your monthly benefits for Federal income tax. If you are a Massachusetts, resident, you should also request that they withhold 5% from your retirement plan distributions for Massachusetts income tax.
You really won’t miss the funds that are withheld to cover your income tax liabilities.
Taxation of Variable Retirement Income Streams
Taxation of Variable Retirement Income Streams is almost always a certainty. If the income that you received from your variable retirement income streams is relatively small – on the order of $2,000 to $3,000 annually – just pay the small amount of income tax due when you e-file your income tax returns in April. However, if the income that you received from your variable retirement income streams is large - $10,000 or more annually – you should make Estimated Tax Payments on the amounts you receive during the year.
Let’s look at an example. Say that the income that you received from your variable retirement income streams during the year was $20,000 and that your Effective Tax Rate (ETR) is 15%. This means that you would need to make a Federal income tax payment of $3,000 to the IRS when you e-file your return in April.
For many taxpayers, payment of a $3,000 tax liability may not pose that much of a strain on their checking account. Other taxpayers may need to transfer funds or sell some stock or mutual funds in order to come up with this $3,000 tax payment. Instead, if the income that you received from your variable retirement income streams was $50,000., you’re looking at a Federal income tax liability of $7,500 or more, which may be difficult to handle.
Tax Tip
Instead of paying this Federal income tax liability out of your checking account, consider paying the amount due directly from your variable retirement income streams. Remember, most interest, dividends and capital gains distributions, and short-term and long-term capital gains income received on your investment portfolio are reinvested directly into the investment account where they originated from, not into your checking account. Ask your investment account fiduciary to make one Federal estimated tax payment directly from your investment account. Schedule this Federal tax payment to be made in late December, the month in which the largest amounts of dividends and capital gains distributions are paid out, rather than on January 15th of the following year.
Massachusetts residents should make an estimated tax payment of 5% of amount of their variable retirement income streams to the MA Dept. of Revenue.
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