The Impact of Taxes on Your Retirement Savings

June 3, 2014

Retirement savings have such a huge impact on our future lives, yet most people spend more time planning a vacation than they spend planning for retirement.

They also know more about what the taxes would be for the unlikely chance of hitting the lottery than they know about what the taxes will be on their own IRAs, 401(k)s and Social Security.

According to the results of a new study by Bankers Life Center for a Secure Retirement of 1,000 Americans age 50 or older with annual household incomes between $25,000 and $75,000, fewer than half understand what taxes will be on:

• Social Security benefits (39 percent of those surveyed)
• Traditional IRA withdrawals (35 percent)
• Roth IRA withdrawal (31 percent)
• 401(k) withdrawals (29 percent)

By not understanding the tax rules that affect their retirement accounts, many Americans may be seriously underestimating the actual amount they will need when they retire.

Many pre-retirees are not aware that if they made pretax contributions to 401(k)s or IRAs, they will be taxed on those contributions and their earnings when they make withdrawals. Of course, in most cases, the income tax rate is likely to be lower after retirement than it was when they were working.

After-tax contributions to IRAs are taxed only on the earnings when withdrawn and not on the withdrawn contributions themselves. Withdrawals from a Roth IRA are 100 percent tax free as long as the taxpayer is at least 59 1/2 years old and has had a Roth for at least five years.

Nearly 60 percent of older Americans surveyed also are not aware that at age 70 1/2 they must begin taking required minimum distributions from their traditional IRAs and 401(k)s or they will incur significant penalties.

And these penalties can be steep. The penalty can equal 50 percent of the difference between the amount that should have been withdrawn and the amount that was withdrawn. The penalty may be waived if the shortfall in the distribution was due to reasonable cause and reasonable steps are being taken to remedy it.

While it’s important to be knowledgeable about penalties that could be imposed, it’s also helpful to know that there are exceptions to penalties.

But 90 percent of survey respondents did not know they could withdraw funds from a traditional IRA without penalty. It’s a good idea to consult a tax advisor for the specifics, but if a taxpayer meets the requirements, early-distributions can be penalty-free if they are:

• Paying for health insurance while unemployed
• Using the money to pay college expenses
• Buying a home for the first time
• Paying for medical expenses

Only 2 percent were aware of all four exceptions.

In addition to the exceptions listed above, the penalty does not apply if the taxpayer dies or is disabled or if the distributions are made equally over the taxpayer’s life expectancy.

As to Social Security, benefits were not subject to tax before 1984. But since then, Social Security payments can be taxed based on the amount of the taxpayer’s non-Social Security income. The higher the non-Social Security income, the greater the portion of Social Security benefits that can be taxed.

Social Security benefits are totally nontaxable if the sum of one-half of a person’s Social Security benefits plus all other gross income plus all tax-exempt interest income is below the following threshold amount:

• $32,000 for married couples filing jointly
• $25,000 for unmarried individuals and married couples filing separately, who did not live together at any time during the year
• $0 for married couples filing separately, who lived together at any time during the year

Above those thresholds, a portion of their Social Security benefits is included in their taxable income.

At the highest income levels, if taxpayers are in the 39.6 percent marginal tax bracket, the tax effect of including 85 percent of Social Security benefits in taxable income effectively causes them to repay about one-third of their benefits to the federal government.

The survey also found that few Americans approaching retirement are aware of tax deductions that potentially might help them during retirement:

• In some cases, taxpayers may claim their parents living outside the home as dependents for tax purposes.
• A higher standard deduction begins at age 65.
• Blindness is a cause for a higher standard deduction.

Many of the middle-income Americans surveyed were unaware of the tax issues involved in retirement because they don’t seek tax or retirement guidance.

More than half (54 percent) have never received any professional retirement guidance, and the same percentage do their own taxes without any external advice or guidance.