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How to Calculate Your Tax Bracket During Retirement

Have you ever wondered how to calculate your tax bracket during retirement?

If so, you’re definitely not alone.

Unfortunately, our federal income tax system is extremely complicated. This results in people having no clue how their taxes are calculated or what tax bracket they fall in.

Thankfully:

The basics of our tax system aren’t too hard to understand if you take the time to learn about it.

Understanding this can make your retirement savings last longer, too. 

As always, consult your tax preparer or advisor about your specific situation. Additionally, we are covering federal income taxes. You may have to pay state tax, too, but each state has their own tax systems.

Why Knowing Your Tax Bracket in Retirement Matters

Knowing what your tax bracket is in retirement is important because it can help you better plan for your taxes. 

In some cases, you may be able to use your knowledge to lower your overall tax liability in one year or over multiple years.

For instance, funds taken out of Roth accounts in retirement are generally tax-free. These could include Roth IRA and Roth 401(k) funds.

On the other hand, you may have to pay taxes on money withdrawn from tax-deferred accounts. These could include traditional IRAs, 401(k)s and other workplace retirement plans. 

Taxable investment accounts may also be required to pay taxes depending on the assets you sell.

How Tax Brackets Work

Before we go any further, it’s important you understand how tax brackets work. Just because you’re in the 22% tax bracket doesn’t mean you pay 22% tax on all of your income.

Instead, our tax system is a marginal tax system.

For each additional dollar of income you earn, you’d pay 22% tax. However, each prior dollar is taxed at the rate for that specific dollar.

For instance, a tax system may tax 10% on the first $10,000 of income, 20% on the next $15,000 of income and 25% on all other income.

In this case, let’s say you have $45,000 of income. You’d owe $1,000 of tax on the first $10,000 of income. Then, you’d owe $3,000 of tax on the next $15,000 of income. Finally, only the last $20,000 would be taxed at the 25% tax rate for $5,000 of tax.

Your total tax bill would be $8,000 and your effective tax rate would be 17.78%. This is calculated by taking your tax bill divided by your income.

How to Calculate Your Tax Bracket in Retirement

The easiest way to calculate your tax bracket in retirement is to look at last year’s tax return

For 2018, look at line 10 of your Form 1040 to find your taxable income. Next, compare your taxable income to the tax brackets and rates for the year which can be found in Table 1 on this page of the Tax Foundation’s website.

Based on your taxable income and filing status, such as single filer or married filing jointly, you’ll find out if your marginal tax bracket was 10%, 12%, 22%, 24%, 32%, 35% or 37% for the year 2018.

It’s important to note:

this won’t tell you your current year’s tax bracket. It will only tell you the top tax bracket you fell in last year.

Each year, the amount of taxable income subject to each tax bracket changes due to inflation and potential tax law changes. You can find the 2019 tax brackets here in Table 1, as well.

That said:

You can use last year’s tax return to figure out how you ended up in the tax bracket you fell in. Then, you can use that information to plan how to you might be able to change that for this year or next year.

What Affects Your Tax Bracket

Ultimately, your tax bracket is calculated based on your taxable income. Getting to taxable income takes multiple steps and calculations. 

Typically, calculating taxable income is based on two major categories of items. These are income items and deduction items.

Income

There are many different types of income that factor into your tax bracket calculation.

You’ll find the majority of types of income on Form 1040 or IRS Form Schedule 1.

Wages, salaries & tips

If you have a part-time job in retirement and receive a W-2, this income impacts your tax bracket.

Taxable interest

Receiving taxable interest counts as income for tax purposes. 

Interest earned from certificates of deposit (CDs) and savings accounts that aren’t in tax-deferred accounts are examples. This income impacts your taxable income which is then used to calculate your tax bracket.

Ordinary and qualified dividends

If you receive ordinary or qualified dividends in a taxable investment account, these types of income impact your taxable income. 

Dividends in tax-deferred or Roth accounts wouldn’t impact this as long as you keep them within the account and don’t distribute them.

Taxable Social Security benefits

Social security benefits are a major source of retirement income for most retirees. 

Part of your Social Security income may be taxable. The taxable portion is included in taxable income and impacts your tax bracket.

Taxable IRAs, pensions, and annuities

Taxable income from IRA distributions, IRA withdrawals, pensions, and annuities all impact your tax bracket calculations. 

Not all IRA distributions are taxable. For instance, Roth IRA distributions are usually tax-free.

Pensions and annuities may or may not be taxable depending on your situation and the particular pension or annuity.

Capital gains or losses

Income from capital gains or losses is also factored into your taxable income. These gains and losses are usually for investments in a taxable investment account or the sale of a large asset such as your home.

Other types of income

If you’re retired, you may still have other types of income.

If you are still earning royalties or own rental real estate, businesses or farms, that income is usually included in taxable income, as well. 

Other sources of income may also be included in taxable income depending on your situation. Consult your tax advisor if you’re unsure.

Deductions

Deductions are a bit easier.

In general, your biggest deduction will be either the standard deduction or itemized deductions. You get one or the other, whichever is larger.

Standard deduction

The standard deduction is a set amount most taxpayers can claim. The amount is determined by your filing status.

Itemized deductions

Itemized deductions are a set of many deductions that you can take instead of the standard deduction.

If your total itemized deductions exceed your standard deduction, it usually makes sense to itemize.

Examples of some itemized deductions, which may be limited, include:

  • State and local taxes
  • Home mortgage interest
  • Gifts to charity
  • Other deductions listed on IRS Form - Schedule A

Other deductions

There are also a handful of other tax-deductible items you may take in addition to the standard or itemized deductions. These include deductions like those for:

  • Qualified business income deduction
  • Educator expenses
  • Health savings account deductions
  • Moving expenses for members of the armed forces
  • The deductible part of self-employment tax
  • Other adjustments to income listed on IRS Form - Schedule 1

How to Control Your Tax Bracket in Retirement

Now that you understand what goes into calculating your tax bracket in retirement, you can use that information to plan for your taxes.

These strategies are fairly basic, but every tax strategy depends on an individual’s unique circumstances.  

Check with your tax advisor to see if these strategies or other more complex strategies may work to help you control your tax bracket. Sometimes, you can save a ton of money by minimizing your taxes through smart decisions.

Manage your taxable income

Since tax brackets are determined based on your taxable income, it’s your taxable income you need to manage. 

Because you know the parts that make up taxable income, it’s easy to see the potential options.

Lower income

First, you can lower your taxable income by lowering your income. 

Some types of income you won’t be able to manage. For instance, your pension doesn’t likely allow you to choose when you want to receive payments. 

Other types of income can be managed. You can take large distributions from your IRA in one year and a much smaller distribution in the next year. 

Depending on your situation, it may make sense to manage your income to lower your taxable income in one year to pay less in federal income tax.

Increase deductions

The other side of the taxable income equation is deductions. If you know you’re going to have a year with a ton of deductions, it can drastically lower your taxable income. 

Similarly, if you know you’ll have a year with hardly any deductions, keeping your income lower can lower your tax liability that year.

Convert assets to Roth accounts

Let’s say you’re usually in the 22% tax bracket. This year you might have a unique situation where you’ll only be in the 10% tax bracket for a year.

You can use this opportunity to convert traditional retirement account assets into a Roth retirement account

Now:

You’ll have to pay income tax on the conversion based on the marginal income tax rate each dollar of the conversion falls in. 

However, if you only convert enough assets to keep yourself in a lower tax bracket, you pay less in income taxes now. Then, you can withdraw the money tax-free later when you’re in a higher tax bracket.

Consult a professional before you do this. It can be complicated. Once you convert assets, you may not be able to hit an undo button if you make a mistake.

0% taxes on long-term capital gains

If you’re in the 10% or 12% tax bracket, you can take advantage of a 0% tax rate on long-term capital gains. 

This doesn’t apply to money in IRAs or Roth IRAs. It mainly applies to investments in a taxable investment account or other capital assets.

As long as the long-term gains don’t push you into the 22% tax bracket, you won’t pay taxes on them. If the gains do push you into the 22% tax bracket, the long-term capital gains tax increases to 15% on each marginal dollar and eventually can increase to 20%.

Now You Know

As you can see, knowing how to calculate your tax bracket in retirement is important. It allows you to understand the tax system. 

It can even save you money by lowering your tax bill if you’re able to take advantage of some tax planning concepts. 

Make sure you consult your tax preparer or tax advisor to see how these concepts can impact your individual situation before you make any financial moves or decisions.

Each person’s tax situation is unique and can complicate even the simplest concepts.