Taxes and Retirement Income
Individuals may receive a variety of income when they retire. Different tax rules apply, depending on the type of income involved. Rules may vary for federal and state income tax purposes. And, starting this year, retirement income can impact the additional Medicare surtax on net investment income. Here is a roundup of the key tax rules for retirement income.
Social Security Benefits
Prior to 1983, Social Security benefits were always tax free. Now Social Security benefits are includible in gross income at zero, 50%, or 85%, depending on overall income (including tax-free interest on municipal bonds and one-half of Social Security benefits), technically called “provisional income” (Code Sec. 86). The applicable income limits on provisional income for each of these inclusion rates varies with filing status.
Benefits are includible in gross income if provisional income exceeds $25,000 if single (including head of household, a qualifying widow(er), or a married person who lives apart for all of the year), or $32,000 if married filing jointly. Those with provisional income over $34,000 if single or $44,000 if married filing jointly include 85% of benefits in gross income. Those with provisional income between these limits (e.g., over $25,000 but not over $34,000 if single) include 50% of benefits in gross income. These threshold amounts are not adjusted annually for inflation; they are statutory.
S.S. Benefits Single Joint
0 <$25 <$32
50% $25-$34 $32-$44
85% >$34 >$44
Married persons filing separately who do not live apart from their spouses automatically include 85% of their benefits in gross income; there is no provisional income threshold in this case.
State income taxes. Even though benefits may be partially includible in gross income for federal income tax purposes, they may be fully exempt from state income taxes. For example, Social Security benefits are not taxed by New Jersey and New York. In Connecticut Social Security benefits are exempt only for taxpayers with federal adjusted gross income below set limits.
Working after retirement. Working does not prevent you from collecting so-called retirement benefits from Social Security. However, if you are under the normal retirement age (currently 66) and you continue to work while collecting benefits, you face a reduction in the benefits. For 2013, benefits are reduced by $1 for each $2 over $1,260 per month ($15,120 annually). Also, earnings from a job or self-employment continue to be subject to Social Security and Medicare taxes, even when collecting Social Security benefits.
Deferred compensation
Employees may have the option of postponing the receipt of certain compensation, such as bonuses, until they retire or attain some other benchmark set by the deferred compensation arrangement (Code Sec. 409A). Deferred compensation is fully taxable for income tax purposes. The reason for deferral is the expectation that the recipient will be in a lower tax bracket when the deferred compensation is received (i.e., after retirement).
However, the deferred compensation is not subject to Social Security and Medicare (FICA) taxes in the year of receipt. Such compensation is subject to FICA in the year in which it was earned, usually at a time when the recipient’s compensation already exceeds the Social Security wage base (e.g., $113,700 in 2013).
Annuity Payments
Payments from commercial annuities are taxable after taking into account the taxpayer’s investment in the contract (Code Sec. 72). Thus a portion of each annuity payment represents a return of the taxpayer’s investment (not taxable) and earnings on the investment (taxable).
There is no automatic or optional withholding for taxes on annuity payments. Annuitants must take the tax on these payments into account for estimated tax purposes.
Distributions From Qualified Retirement Plans and IRAs
All distributions from qualified retirement plans and deductible IRAs are fully taxable. (There are some minor exceptions.) A special averaging rule for lump-sum distributions from qualified retirement plans (but not IRAs) applies only to those born before January 2, 1936. Even if retired, distributions from an IRA before age 59-1/2 or from a qualified plan before separating from service when at least 55 years old are also subject to a 10% penalty (unless some penalty exception applies) (Code Sec. 72(t)).
Employee annuities are fully taxable if paid entirely with pre-tax dollars. If, however, employees contribute after-tax dollars, only a portion of each payment is taxable. Special rules apply to determine the amount of the annuity payments includible in gross income; these rules are simpler than the rules for determining the taxable portion of commercial annuities.
Different rules may apply for state income tax purposes to distributions from qualified retirement plans and IRAs.
- New York exempts up to $20,000 in distributions from retirement plans and IRAs for those who are age 59-1/2 and older. All military, civil service, and New York state and local government pensions are fully exempt.
- New Jersey excludes pensions only by those who are age 62 or older, with a dollar limit on the total amount excluded.
- Connecticut excludes only 50% of military pensions.
Distributions from Roth IRAs are tax free as long as the funds are withdrawn after age 59-1/2 and after satisfying a five-year period for the account (Code Sec. 408A).
Impact of the NII Tax
Starting in 2013, there is a Medicare surtax on net investment income (NII). More precisely, a tax of 3.8% applies to the lesser of net investment income for the year or modified adjusted gross income (MAGI) over a threshold amount (Code Sec. 1411). The threshold amount is $200,000 for singles, $250,000 for joint filers, and $125,000 for married persons filing separately.
Retirement income may or may not be treated as investment income for purposes of this surtax. Retirement income treated as investment income includes, but is not limited to, interest, dividends, commercial (nonqualified) annuities, royalties, rents, passive business income, and capital gains.
Types of retirement income that are not treated as investment income include tax-exempt interest, veteran’s benefits, Social Security benefits, Alaska Permanent Fund dividends, and distributions from qualified retirement plans and IRAs. However, even if certain types of retirement income are not treated as investment income, to the extent they are included in gross income they increase MAGI, which can help to trigger the surtax on non-retirement income.
Paying Income Taxes on Retirement Income
For the most part, if retirees anticipate owing taxes on their retirement income they usually must pay the taxes through quarterly estimated tax payments. Those who fail to pay enough estimated tax can face a penalty. However, the penalty may be waived for someone age 62 or older who retired in the current or prior year and failure to pay the necessary estimated tax is due to reasonable cause and not to willful neglect. The penalty waiver is not automatic; it must be requested on Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts.
The need to pay estimated taxes can be minimized or avoided entirely by having withholding on retirement income. Here are some withholding rules for certain types of retirement income:
- Social Security benefits. Retirees can voluntarily elect to have federal income tax withheld in their benefits at the rate of 7%, 15%, 27%, or 30%, at the taxpayer’s option. To initiate voluntary withholding, a taxpayer must send a completed IRS Form W-4V, Voluntary Withholding Request, to the Social Security Administration (not the IRS). Withholding then commences within a few weeks of submission. To stop withholding or change the rate, a new Form W-4V must be filed.
- Retirement plan distributions. Distributions from qualified retirement plans are subject to an automatic 20% withholding rate. This withholding cannot be waived by the recipient (retiree). However, with respect to other distributions from qualified plans and IRAs, a voluntary withholding form (Form W-4P, Withholding Certificate for Pension or Annuity Payments) can be used to increase or reduce, or eliminate withholding. Withholding from periodic payments of a pension or annuity is figured in the same manner as withholding from wages. If no Form W-4P is submitted to the payer, the payer must withhold on periodic payments as if the recipient were married claiming three withholding allowances. Generally, this means that tax will be withheld if the pension or annuity is at least $1,680 a month. However, the recipient can indicate a different number of withholding allowances to change the amount of withholding; no set dollar amount for withholding can be specified.
Conclusion
For many seniors, Social Security and benefits from qualified retirement plans and IRAs are their only sources of retirement income. For them, there may be a new tax return in the offing. The Senior’s Tax Simplification Act of 2013 (H.R. 38), introduced earlier this year, would create Form 1040SR for those age 65 or older who have “simple” returns. It remains to be seen whether this measure will be enacted.
Having sufficient income in retirement is dependent not only on the gross amount of retirement income but on the after-tax results. Tax planning for retirement income can help ensure sufficient funds for a comfortable retirement.
Sidney Kess, CPA, J.D., LL.M., has authored hundreds of books on tax-related topics. He probably is best-known for lecturing to more than 700,000 practitioners on tax and estate planning.
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