Some seniors find that money gets tight once they stop working. Such is the challenge of being retired. But one thing that tends to really throw seniors off-course is the fact that many common retirement income sources are subject to taxes. Here are a few you should know about so you can make a plan to cover your tax bill.
1. Social Security benefits
Unless Social Security is your only source of retirement income, there's a good chance you'll wind up having to pay taxes on some or most of those benefits. The income thresholds at which federal taxes for Social Security kick in are pretty low — and they haven't changed in decades. So even if you consider yourself a fairly low earner, the IRS might still get a piece of your benefits.
In addition, there are 12 states that impose their own taxes on Social Security benefits. Some exempt lower-income seniors from those taxes, but it's important to know if your state is on this list — and what its tax rules entail.
2. Traditional IRA and 401(k) withdrawals
The money you withdraw from a traditional IRA or 401(k) plan will be subject to taxes. And to be clear, at some point, you will face those taxes, because these accounts force you to begin taking required minimum distributions (RMDs) once you turn 72.
If you want to get out of paying taxes on your retirement plan withdrawals, you'll need to house your savings in a Roth IRA or 401(k). The former will allow you to avoid RMDs altogether, which gives you more flexibility. Roth 401(k)s have RMDs, but they don't create a tax liability.
3. HSA withdrawals for non-medical spending
If you have money in a health spending account, once you turn 65, you can take a withdrawal for non-medical purposes without facing the steep penalty you'd be looking at if you were younger. But HSA withdrawals that aren't used to cover qualified healthcare expenses are subject to taxes the same way traditional IRA and 401(k) withdrawals are.
4. Capital gains from the sale of municipal bonds
Retirees are often told that municipal bonds are a great investment. That's because the interest they pay can serve as a steady income stream. And also, that interest is always exempt from federal taxes.
But if you sell municipal bonds at a gain, you'll face taxes in that situation. The tax-exempt status of municipal bonds only applies to the interest income you collect from them.
5. Savings account interest
Savings accounts are finally starting to pay a respectable amount of interest. And during retirement, it's a good idea to have a year or two's worth of bills tucked away in savings. That way, if your investments lose value, you won't have to cash them out at a loss to come up with the money to pay your living costs.
But higher savings account rates could leave you owing the IRS more money. That's something to be mindful of.
Taxes are something you can't shake at any point in life, including retirement. But knowing what income sources of yours are taxable could help you plan more efficiently and avoid unpleasant surprises that throw your finances for a major loop.
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