Why you'll pay less tax in retirement
Most people believe they'll always pay more income tax every year. And it sure feels like that's the case, which is understandable given that from your mid-20s, taxable income generally increases annually for most workers. And higher income typically means paying more income tax.
But studies of who's paying how much in income tax show the share of U.S. households that paid federal income tax peaks at around age 50, at nearly 80 percent. By age 65, that drops to about 50 percent. By the time most people settle into retirement, they're paying less income tax. Here are a few reasons.
First, most people will have lower income in retirement. The standard rule has been that you can afford to retire on about 70 percent to 80 percent of your working income, given reduced living expenses.
Older Americans also get a lot of tax breaks. These include increased deductions, higher amounts that can be contributed to tax-advantaged retirement accounts and penalty-free withdrawals from retirement accounts.
One big tax savings for retirees is that they no longer pay the Social Security (FICA) tax. That's because income from pensions, withdrawals from retirement accounts, dividends and interest income or Social Security retirement benefits aren't categorized as income from earnings and therefore are exempt from Social Security wage taxes.
Speaking of Social Security benefits, this income is tax-free for many people, and for most it's only partly taxable, depending on a special definition of income.
Finally, many people who pay state income taxes will find that many states give special breaks to residents who receive specific types of income in retirement. Many states don't tax retirement benefits received from Social Security. And many exempt pension income and withdrawals from 401(k) plans and IRAs. For example, each New York resident can receive up to $20,000 annually from retirement plans and IRAs free of state income tax.
