As you go through life, you will encounter several "life-changing" moments. Some are good, such as graduating college or having a child, while others are bad, such as losing a parent or going through a divorce. These moments can also bring changes to your financial life, including how much tax you owe and how it is paid.
This article addresses taxes in retirement. I realize this is not chronologically accurate, but it is an issue that several people are not prepared for when they enter retirement.
Income and deductions
A retired taxpayer will likely have very different income and deductions than they had earlier in life, maybe even than the year before. Their wage income will be replaced by distributions from retirement plans, investment income and Social Security. Personal exemptions for children and mortgage interest will be replaced by charitable contributions and medical expenses. Changes in income and deductions must be considered when determining how much tax will be owed each year.
Social Security
There's no easy way to say it: if you have other sources of income, up to 85% of the gross Social Security benefits you receive are taxable. This often comes as a surprise to retired taxpayers, because there is often no tax withholding against this income. However, you can elect to have Federal withholding taken from your SS benefits if you don't want to change the withholding on your retirement distributions. Fortunately, SS benefits are not taxed in several states.
Paying taxes
The most challenging part of determining taxes in retirement is determining your income from all sources and electing tax withholding to cover all of it (or pay estimated taxes). If you are taking distributions from a retirement plan, they will give you the option to withhold taxes on that distribution. But, this withholding will be based on that distribution alone, and most likely will not cover investment income or Social Security benefits. The key is to set your withholding high enough to cover taxes on all of your income, not just one source.
In all, it is important for individuals that are nearing or entering retirement to meet with their tax advisor to determine tax implications of retirement. Your tax advisor will consider changes in your income and deductions and advise on how much to withhold from retirement distributions or quarterly estimated tax payments that need to be made.