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Pre-retirement vs. Retirement Income Taxation

When thinking about taxes in retirement—surprise, you still must pay taxes in retirement—most people look at their pay stubs and see how much they are paying in taxes. However, there are some taxes on your paystubs and W-2 that you do not have to pay in retirement. Mainly, this is your OASDI (Old Age, Survivors and Disability Income program-think Social Security) and Medicare Taxes on your wage and self-employment income. This is a considerable number. Here is the breakdown:

OASDI

The OASDI tax is 12.4% of your income up to $142,800 (2021) and $147,000 (2022). If you are an employee (W-2), then you pay 6.2% and your employer pays the other 6.2% up to the limit for the current year. If you are self-employed, you pay the entire 12.4%, but you get a credit for half (6.2%) on your tax return.

Medicare Taxes

The Medicare tax is a lower percentage, however, there is no cap on the income like there is with OASDI taxes. The Medicare tax is 2.9% on ALL income. If you are an employee, then you only pay half (1.45%), and your employer pays the other half. Again, if you are self-employed, then you pay the 2.9%, with a credit for half.

  • Additional Medicare Tax for High Income
    • There is an Additional Medicare tax for high earners. The tax rate is 0.9% and it starts at the $200K income level for single filers and $250K income level for married filing joint. You pay an extra 0.9% on all income above these levels and you do not split the cost with your employer.

The above OASDI and Medicare taxes are employment taxes that you do not have to pay in retirement because you are not employed any more. If you do some part time work during retirement, then you will be subject to these taxes. These taxes are in addition to your Federal and State income taxes.

Retirement Income

When I talk about retirement income, I am referring to pensions and IRA income. Pensions and Traditional IRA’s (age 59.5+) are usually subject to Federal and State Income Taxes, but you do not have to pay the 15.3+%OASDI and Medicare taxes on this income. ROTH IRA’s (if the rules are met) will not be subject to Federal and State Income taxes. Also, your Social Security income is not subject to the Medicare and OASDI taxes and has favorable tax rates. The maximum amount of your Social Security that can be taxed at ordinary income rates is 85% of your Social Security income. Additionally, a lot of states do not tax Social Security income.

Investment Income

Investment income is taxed the same whether you are retired or not. These income types are Interest (1099-INT), Dividends (1099-DIV) and Capital Gains (1099-B). Some municipal bonds can be tax free at the federal and state levels, but otherwise, interest is taxed at ordinary income rates. Qualified Dividends can have favorable tax rates as well as Long Term Capital Gains.

You may be thinking that you have investments in IRA’s that have interest, dividends, and capital gains, how do these favorable tax rates come into play then? The answer is that they do not. Your Traditional IRAs are tax deferred—this means that you do not owe any taxes until you pull the money out, therefore, the interest, dividends and capital gains are tax free within the IRA. As soon as you pull the money out (1099-R), then you are subject to ordinary income tax rates on the distribution (and penalties if you are under age 59.5).

If you have any annuities, these are also taxed a little differently. For IRA annuities, you are taxed just like Traditional IRAs and ROTH IRAs, depending on the IRA annuity registration. For non-IRA annuities, the gains (excess of your purchase) are taxed at ordinary income rates. Also, all the gains come out first and you pay taxes on these gains. Then the rest is considered return of principal and you are not taxed on this amount because you have already paid income taxes on these dollars prior to purchasing the annuity.

If you have investment income in excess of $200K (single) or $250K (married filing joint), then you may be subject to the Net Investment Income Tax of 3.8% only on your Investment Income.

In conclusion, the biggest difference with your taxes when you stop working is not having to pay the OASDI and Medicare taxes that you pay while employed.

Financial Journey LLC is a registered investment advisor offering advisory services in the state of Virginia and in other jurisdictions where exempted. Information provided is for educational purposes only and not, in any way, to be considered investment or tax advice.

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