Retirement savings have such a huge impact on future lives, yet most people spend more time planning a vacation than they spend planning for retirement. They also know more about what the taxes would be for the unlikely chance of hitting the lottery than they know about what the taxes w ill be on their own IRAs, 401(k)s and Social Security.
According to the results of a new study of 1,000 Americans age 50 or higher by Bankers Life Center for a Secure Retirement, fewer than half understand what taxes will be on:
- Social Security benefits (39% of those surveyed)
- Traditional IRA withdrawals (35%)
- Roth IRA withdrawals (31%)
- 401(k) withdrawals (29%)
By not understanding the tax rules that affect their retirement accounts, many Americans may be seriously underestimating the actual amount they will need when they retire.
Many pre-retirees are not aware that if they made pretax contribution s to 401(k) s or IRAs, they will be taxed on those contributions and their earnings when they make withdrawals. Of course, in most cases, the income tax rate is likely to be lower after retirement than it was when they were working.
After-tax contribution s to IRAs are taxed only on the earnings when withdrawn and not on the withdrawn contributions themselves. Withdrawals from a Roth IRA are 100 percent tax free as long as the taxpayer is at least 59 1/2 years old and has had a Roth for at least five years.
Nearly 60 percent of older American s surveyed also are not aware that at age 70 1/2 they must begin taking required minimum distributions from their traditional IRAs and 401(k)s or they will incur significant penalties. These penalties can be steep - The penalty can equal 50 percent of the difference between the amount that should have been withdrawn and the amount that was withdrawn.
The penalty may be waived if the shortfall in the distribution was due to reasonable cause and reasonable steps are being taken to remedy it. While it’s important to be knowledgeable about penalties that could be imposed, it’s also helpful to know that there are exceptions to penalties.
Up to 90 percent of survey respondents did not know they could take early withdrawals from a traditional IRA without penalty if certain exceptions apply. It’s a good idea to consult a tax adviser for the specifics, but if taxpayers meet the requirements, early distributions can be penalty-free if they are:
- Paying for health insurance while unemployed
- Using the money to pay college expenses
- Buying a home for the first time
- Paying medical expenses
Only 2% were aware of all four exceptions.
In addition to the exceptions listed above, the penalty does not apply if a taxpayer dies or is disabled or if the distributions are made equally over the taxpayer’s life expectancy.
As to Social Security, benefits were not subject to tax before 1984. But since then, Social Security payments can be taxed not know they could take early withdrawals based on the amount of the taxpayer’s non- Social Security income.
The higher the non-Social Security income, the greater the portion of Social Security benefits that can be taxed.
Social Security benefits are totally nontaxable if the sum of one-half of a person’s Social Security benefits plus all other gross income plus all tax-exempt interest income is below the following threshold:
- $32,000 for married couples filing jointly
- $25,000 for unmarried individuals and married couples filing separately, who did not live together at any time during the year
85 percent of Social Security benefits in taxable income effectively causes them to repay about one-third of their benefits to the federal government.
The survey also found that few Americans approaching retirement are aware of tax deductions that potentially might help them during retirement:
- In some cases, taxpayers may claim their parents living outside the home as dependents for tax purposes.
- A higher standard deduction begins at age 65.
- Blindness is a cause for a higher standard deduction.
Many of the middle-income Americans surveyed were unaware of the tax issues involved in retirement because they don’t seek tax or retirement guidance.
More than half (54 percent) have never received any professional retirement guidance, and the same percentage do their own taxes without any external advice or guidance.