Tax day is April 18th this year, and it will be an unpleasant day for millions of American working households. But cheer up: your tax situation likely will lighten up a bit when you retire.
The Internal Revenue Service takes it easy when it comes to taxation of Social Security, and many retirees drop into lower tax brackets that help soften the tax bite taken from pensions, IRAs dividends and capital gains. Many states exempt Social Security from taxation, and a handful exempt all retirement income.
Taxable income does tend to fall in retirement, when wage income stops.
In 2013, about 9.7 percent of households were over age 65 and paid neither federal income taxes nor payroll taxes, according to the Urban-Brookings Tax Policy Center. They are part of the 43.3 percent of all households that had no income tax liability that year – mostly because they had income too low, or could offset income with deductions and personal exemptions.
All told, 35 percent of seniors’ taxable income in 2013 came from traditional pensions, 401(k)s and IRA withdrawals, according to IRS data. Wages are the second highest category of taxable income – 23 percent – while Social Security accounts for 13 percent. The remainder of taxable income received by seniors is a mix of qualified dividends, taxable interest and capital gains.
Taxpayers in the 15 percent bracket or lower do not pay taxes on long-term capital gains and qualified dividends. This year, that protects single filers with taxable incomes up to $37,650 and joint filers earning up to $75,300. Moreover, seniors also tend to make greater use of itemized deductions than younger taxpayers.
Social Security income is subject to taxation, but 15 percent of benefits are exempt. And taxes kick in only if your income is above $25,000 (single filers) or $34,000 (joint filers).
Meanwhile, states are all over the map when it comes to their policies on taxing retirement income.
Twenty-nine states (including the District of Columbia) that have a broad-based income tax exempt all Social Security from tax; seven states tax some Social Security benefits but provide an exemption that is more generous than what is available at the federal level. Six states tax Social Security benefits using the federal formula. And a handful of states that have a broad-based income tax (Illinois, Mississippi and Pennsylvania) exempt all retirement income from taxation. Meanwhile, 36 states with an income tax allow some exemption for private or public pension benefits. Learn more about how your state treats retirement income at the Institute on Taxation and Economic Policy.