I’ve got a little good and bad news for you when you reach retirement. The good news is that there is a really good chance that your taxes will go down in retirement! The bad news is that these taxes aren’t gone completely. In fact, taxes in retirement can actually be more complicated. For example, in retirement you typically don’t have to pay FICA taxes any longer. FICA taxes of course is a payroll tax that helps pay for social security. Yet, you have to pay taxes on social security which is funded from a tax that you paid for your whole working career. I never said that taxes made sense. This article explores the typical sources of in income a retiree will have and what taxes you will have to pay on this income.
There is a proposal to eliminate the the Michigan pension tax. Read more here about the proposal and why it may not be great for Michigan retirees.
First a handy chart that shows the typical retirement sources and the taxes you pay on each source of income.
A breakdown of the different tax rates:
The more you earn, the higher you pay in federal taxes. The lowest tax bracket currently is 10% and the highest is nearly 40%. Typically, we find most retirees will fall in the 12% or 22% marginal tax bracket and pay an effective tax rate around 10-15% of their income. This can vary greatly depending on sources of income.
Michigan State Tax
A flat tax of 4.25%
This is the big tax that for most retirees goes away unless you work part-time to help supplement your income. The FICA tax is currently 7.65% of all earned income.
Now, let’s discuss your typical income sources and the taxes you pay on each source:
There are thirteen states that tax social security, luckily, Michigan is not one. Before you decide to pack up a U-Haul and move to Florida to escape those state taxes, remember that one of your biggest sources of income in retirement, social security, is Michigan state tax free. Not only is social security Michigan state tax free, it also has reduced federal taxes.
At a minimum, 15% of your social security comes back tax free and then you pay normal federal taxes on the remaining amount. If your income is low enough, all of your social security benefit will be tax free. Here is an article from the Social Security Administration if you want to calculate your exact taxes. For a general rule of thumb, if you are married and have income over $55,000 or single and have income over $40,000, there is a good chance that you will be paying normal federal taxes on 85% of your social security benefit. Less than these numbers and more of your social security benefit comes back tax free.
Pension and Pre-tax Retirement Withdrawals
I’ll lump these together because it doesn’t matter if your income comes from pension, pre-tax retirement withdrawals, or combination of both; your taxes are the same. The full amount of the distribution is subject to federal income taxes. Of course, the more you earn, or withdraw from your retirement savings, the higher your federal tax rate will be and the more you will pay in taxes.
Michigan Retirement Taxes Are Based On Your Age
Michigan state taxes on pensions and pre-tax retirement withdrawals are a little more complicated. In 2012, Michigan made some changes and went from very retiree tax friendly to less tax friendly. Now, the amount of state taxes that you pay is based on the age of the participant.
If you were born before 1946: If you are single, the first $51,570 of pension and pre-tax withdrawals are Michigan state tax free. If you are married, the first $103,140 of pension income is state tax-free.
If you were born between 1946 and 1952: The first $20,000 if you are single and $40,000 if you are married is state tax free.
If you were born after 1952: All pension and pre-tax retirement income is subject to Michigan state taxes.
If you are under the age of 65, be prepared to pay state taxes and federal taxes on the full amount of your pension and pre-tax withdrawals.
Roth 401(k) and Roth IRA Withdrawals
The full amount of your Roth withdrawals are tax-free both for both state and federal taxes as long as you are over 59 ½ years of age and started your Roth account 5 years ago or more. Nope, it doesn’t get any better than this. Hopefully you learned this at an early enough age to have some Roth money built up.
Is your spouse nagging you to get out of the house and earn some money? Remind him or her that you have to pay federal, state, and FICA taxes on anything that you earn. That part-time job at Home Depot doesn’t sound so appealing now does it.
No, taxes don’t go away in retirement, they just get more complicated. On some income you pay federal and state taxes on the full amount of your income (pensions and pre-tax retirement withdrawals). On other income you pay no state taxes and reduced federal taxes (social security). There is even some income that you don’t pay any taxes on (Roth distributions). Last, there is income that you have to pay the additional FICA tax (part-time job). Now that you know the different types of taxes that you will pay in retirement, the key is putting together a retirement income strategy that helps maximize income and minimize taxes.
Need more help?
Bryan Haggard CFP®, CFA is a Michigan based fee-only financial planner. He specializes in working with families to help them live a stress-free retirement. Interested in putting together a plan to help you meet your retirement goals? Schedule a time to meet below.