How your tax burden lightens when you retire

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.

Learn more about retirement income and taxes at Reuters Money.

Comments

  1. dan hylkema says:

    Why should social security be taxed in the first place ? We are double taxed on it . Already payed tax on before it went into the system. Ridiculous !!!!

  2. I wonder what the government will do when the entire baby boom generation is retired and the tax base drops. Knowing this government and the significant number of people who live off of social benefits increases, not sure how the system will be able to continue.

    Do I smell higher taxation of retirement benefits. Say no now, but watch out.

  3. Mark Miller says:

    Dan, we aren’t taxed on Social Security itself on the front end. The payroll tax is levied as a percent of wages (split between workers and employers). That is the contribution that generates the benefit, which itself is based on a complex formula driven by earned wages. Taxation of income is based on the same tax policies driving tax of pensions, IRAs, 401ks etc.

  4. Mark Miller says:

    If taxation of benefits increases, that is a move to means-test the program, since the tax burden would be born by more affluent beneficiaries. Far more likely, and smarter in my view, is increased front-end revenue via raising the cap on wages subject to taxation and/or very gradual increase in payroll tax rates.

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