How Are My Federal Taxes Calculated When I Retire?

When you retire and start drawing Social Security, those benefits, dividends and interest from investments, and pensions may constitute your entire income. Some things, such as Roth IRA distributions, are not subject to federal income taxes. Other sources of income, including wages if you keep working, may be partly or entirely subject to income taxes. Knowing how federal taxes are calculated when you retire can help you better plan the financial aspects of your retirement.

Considerations

When you reach age 65, most sources of income continue to be subject to federal income taxes just as they were before you reached retirement age. This means that if you have substantial taxable investment income or wages you must pay federal taxes and file a tax return each year. Since many people have retirement plans like traditional IRAs, this calls for some careful planning. Distributions from such "tax-deferred" plans are taxable when withdrawn. Consequently, if you withdraw all of these funds in a single tax year, you may be paying a high marginal tax rate on much of the money. You'll pay a lower rate by spreading the distributions out over several years.

Deductions

At age 65 you are entitled to add to the standard deduction you can claim on your tax return. Itemizing deductions is not necessary. For married persons filing jointly, the additional deduction was $1,400 as of 2010. For other filing statuses, the additional amount was $1,100. The effect is to reduce your taxable income by that amount. A tip: many states also increase deductions from state income taxes when you turn 65.

Social Security

If your retirement income is limited to Social Security or equivalent Railroad Retirement benefits, don't worry. If you don't have other income, those benefits are not subject to federal taxes. If you have other sources of income such that your modified adjusted gross income (AGI) exceeds a base amount, then up to 85 percent of your benefits may be taxable.

Taxable Benefits

To determine whether your Social Security benefits may be taxable, first you need to add up all other income. This includes wages, taxable and nontaxable investment earnings and other pensions or income. Next, divide your annual Social Security/Railroad Retirement benefits in half and add that to your other income to find your combined income. As of 2010, for persons filing as individuals, if your combined income is over $25,000, up to 50 percent of your benefits may be taxable. If the combined income is over $34,000, up to 85 percent may be taxable. If you are married filing jointly, the figures are $32,000 and $44,000, respectively.

Payments

If you find that part of your Social Security or Railroad Retirement benefits may be taxable, you must file either form 1040 or 1040A. You include the taxable amount with the rest of your taxable income when you calculate federal income tax. In addition, you may avoid a large lump sum payment next year in three ways. You can ask your employer to withhold more tax from your paycheck if you are working. If not, you may either file and pay estimated taxes each quarter or ask the Social Security Administration to withhold taxes from your benefits check.