Common Misinformation about Taxes in Retirement
Income tax has essential implications on one’s quality of life in retirement, and there are a few pieces of common misinformation about taxes in retirement. Misinformation about income tax before or during retirement could become an expensive mistake to a retiree. Often this misinformation leads to miscomputations and, upon realization, your retirement plan is thrown in disarray. Here are some of the common miscomputations about taxes in retirement:
One of the most common mistakes that people make, out of fear and misinformation, is overestimating their tax rate in retirement. The primary source of this ignorance is the assumption that all income in retirement is taxed at the same tax rate. However, as a retiree, you do not earn a salary like you did before, meaning that your taxable income is significantly reduced. The major taxable income is your social security benefits, but this is actually lower than your previous salary. This drops your tax code further to a lower tax bracket. One might argue that contributions to traditional IRAs are taxed using the income bracket; however, even if you retire in the same tax bracket, the tax rate applied may be lower.
Another common misconception about taxes in retirement arises from the inaccurate information of trading your capital losses for compensations in tax returns. It is true that capital losses can be harvested from your income taxes, but it is not as easy as filing a tax return and claiming the losses. Most people kick off this process only to then realize that it might not be in their best interest to claim the losses.
To claim reimbursement for a capital loss on your IRA, all your retirement savings accounts must be emptied to zero balance. For example, if the value of your 401k went down, and you want to recoup this loss by harvesting it from your income tax, you must withdraw the balances from your SEP, 401k, or SIMPLE IRAs for the computation of the actual loss vis-à-vis the tax claim to be accurate.
Taxing different types of investments
Most people are misguided about how income tax is applied for various investment accounts. First, it is important to highlight that income tax for deferred accounts is affected after you make a withdrawal. Therefore, if you have $100,000 in your traditional IRA and your distribution is $20,000, you will incur charges on the $20,000 and not the entire $100,000. It is also important that you understand the conditions for qualifying for distributions. Making an early withdrawal attracts taxes and other penalties. For Roth accounts, qualified withdrawals are tax-free and without mandatory distribution. Withdrawals from Roth IRA are qualified if the member has contributed for at least five years and they have attained age 59 1/2.
Consequently, traditional IRAs are charged an ordinary tax rate. For other long-term investments, including savings accounts and stock/brokerage accounts, the principal may be accessed tax-free, but the dividends and interests attract a capital gains tax. Therefore, computation of projected tax should be based on the gross capital gains after liquidation of the asset, not on the principle sum.
To learn and understand more about common miscomputations about taxes in retirement, register for a free workshop event near you.