Here is everything you need to figure it out
You might think you know how much you have saved for retirement and whether you will get money from Social Security or a pension. However, do you know how that money will be taxed? The sources of your retirement income and how much retirement income you draw each year will determine your taxes in retirement. Your taxes will also determine how much money you really have to live on.
It is imperative that you understand how your retirement income will be taxed. If you are still working, knowing this information will help you figure out how much you need to save before you can retire. If you are already retired, it will tell you whether you need to do some additional planning to avoid running out of money. Understanding how taxes will affect your retirement can help you pursue ways to minimize your tax bill and maximize your retirement income.
How Is Social Security Taxed in Retirement?
You might be wondering, “If I already paid Social Security taxes while I was working, why do I have to pay taxes on my Social Security benefits in retirement?” On the surface, it sounds crazy, but here is a closer look.
Let’s say your monthly pay as an employee is $5,000. The Social Security tax rate is 6.2%. That means your employer withholds $310 from your pay each month and sends it to the federal government. In addition, your employer contributes 6.2% on your behalf. Your employer pays no tax on that money. In total, $620 goes toward Social Security, and none of it is taxed. In the abstract, the government then hangs on to that $620 until you turn 62 or older and file a claim for Social Security retirement benefits. Then it gives you back your $620. No one has actually paid taxes on the $620 yet.
If it is your only income, you do not owe taxes on it: Your income will be too low to be taxable. If you are also drawing $3,000 from your IRA and $2,000 from a pension, then you might owe taxes on it.
In reality, there is no federal government Social Security account with your name on it, and you do not get back the same amount you pay in. In fact, many workers get back more. Still, it is true that the government does not actually collect taxes on that money during your working years. It merely holds onto it for you. That seems to be the logic, anyway. So how do you know if you will owe taxes on your Social Security retirement benefits?
Check out this chart:
Where It Gets Confusing
The “combined” in combined income is where things can get confusing. It consists of your adjusted gross income, your nontaxable interest income, and half of your Social Security benefits.
Adjusted gross income is your gross (total) income minus adjustments to that income. Common sources of gross income include wages, salaries, tips, interest, dividends, IRA/401(k) distributions, pensions, and annuities. Common adjustments to gross income include health savings account contributions, deductions for IRAs, student loan interest deduction, alimony paid, and contributions to self-employed retirement plans.