According to a recent AARP survey, seventy percent of workers 45 years old and older have other ideas about retirement than just sitting back in their favorite recliner. They plan to work during their retirement years. While some will work to earn extra money to supplement their pensions and savings, nearly a third will work primarily for a sense of purpose and enjoyment. To the extent that this wave of impending retirees is going to be relying on Social Security for their retirement income, some important tax considerations should be taken into account before deciding how much to work and earn during retirement.
Working retirees can be impacted in three important ways under the tax code and Social Security rules. The most obvious is that the extra income earned from employment could push them into a higher tax bracket. For many retirees, the combination of their Social Security payments, company pensions, annuities, and other investment income is not much less than what they were earning before retirement. Adding income from employment, at a minimum, will leave these retirees in the same tax bracket they were in before retirement, and may actually increase their income tax by exposing them to a higher marginal tax rate. So, counting on lower income taxes to reduce expenses during retirement may not be a viable strategy, particularly if you plan to work in your golden years.
Working during retirement can also have a significant impact on how much of your Social Security benefits are taxable. To figure out how much of your benefits are subject to tax, first compute your 'provisional income' by adding one-half of your Social Security payments to the total of your income from pensions, wages, interest, dividends and other taxable income plus any tax-exempt interest income you received. As long as your provisional income is less than $32,000 (married filing jointly) or $25,000 (single; head of household), none of your Social Security benefits are taxable. If your provisional income falls between $32,001 and $44,000 (married filing jointly) or $34,000 (single), 50% of your Social Security benefits are taxable. Take in more than $44,000 (married filing jointly) or $34,000 (single) and up to 85% of your benefits will be subject to tax. Put another way, if working pushes your income above these limits, you could lose as much as 30 cents out of each dollar you receive in Social Security.
Older retirees should also be aware of the required minimum distribution rules on their traditional IRAs and other qualified retirement plans such as 401(k), 403(b) and simplified employer plan (SEP) accounts. These distributions must be taken starting at age 70.5 even if you are still working and must be included in your provisional income in the year they are received. Adding these distributions to income from work and other income can expose more of your Social Security payments to income tax.
While not part of the tax code, younger retirees who choose to start receiving Social Security at age 62 rather than waiting until their full retirement age should be aware that their employment income could dramatically reduce the amount of Social Security benefits they receive. Under the Social Security rules, your Social Security benefits will be reduced by $1 for every $2 earned, either as an employee or in net earnings if self-employed, in excess of $12,000 in 2005. Income from investments, interest, pensions, annuities, and capital gains are not included in this limit. Once full retirement age is reached, this benefit reduction no longer applies Social Security benefits are not reduced regardless of how much a retiree earns.
Let's look at an example to see how this works. Suppose you start a business building children's furniture and have a profit or net earnings of $15,000 in 2005. You also receive $500 monthly ($6,000 per year) from Social Security. Because your net earnings from self-employment exceed the $12,000 annual limit by $3,000, your Social Security payments will be reduced by $1,500 per year, making your monthly benefit $375 instead of $500.
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