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3 Tax Mistakes That Could Ruin Your Retirement

No matter how much you try to avoid it, Uncle Sam will always take a chunk out of your paychecks.

The same is true in retirement, although taxes in retirement can potentially have greater consequences than when you're working -- because you'll likely be living on a fixed income in retirement, spending more than you anticipated can throw off your entire plan. And if you're not prepared for them, taxes can take a serious bite out of your retirement budget.

To ensure your retirement savings go as far as possible in your golden years, there are a few tax mistakes you should do your best to avoid.

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1. Not accounting for taxes at all

It's easy to forget about taxes when you're saving for retirement. When you get caught up in determining how much you expect to spend in retirement and how much you should be saving, taxes may not figure into that equation.

However, the only way to completely avoid paying taxes on your retirement account withdrawals is to store all of your savings in a Roth IRA, where your contributions are taxed upfront but you can withdraw your money tax-free. If you have money in a different type of retirement account -- such as a 401(k), 403(b), or traditional IRA -- you can expect to pay income taxes on the money you withdraw from your retirement fund.

There are a few ways to trim your tax bill in retirement so you're not caught totally off-guard. One option is to invest primarily in a Roth IRA. You'll still pay taxes when you make the initial contributions, but it may be easier to plan for retirement when you know that the money in your account is that amount you'll be able to spend.

Another way to prepare for retirement taxes is to start thinking of your savings goals in terms of pre-tax dollars. For example, say you estimate you'll need $50,000 each year to pay all your bills in retirement, and you base your retirement plan around that number. Even if you save according to your plan and you can afford to withdraw $50,000 per year, you'll actually end up with less than that once taxes are taken out. Instead, you might want to increase your annual spending estimate to, say, $65,000, so that you'll have roughly $50,000 each year to spend after taxes. Of course, the actual numbers will vary based on your tax bracket and your state's tax rate, but figuring taxes into your retirement plan can help avoid any surprises.

2. Forgetting about income tax on Social Security benefits

Yes, you'll likely still owe taxes on your benefits even when you've been paying Social Security taxes throughout your entire career. There are different thresholds for how much you'll pay in taxes, and it depends on your income. If your benefits are your only source of income in retirement, you may get away with not paying any taxes. However, the majority of people will have to pay taxes on at least a portion of their benefits.

The first step to determining how much you'll owe in Social Security taxes is to estimate your combined income, which is half of your annual Social Security benefit amount plus all your other annual retirement income (money from a pension, savings from your retirement fund, etc.). So if you're receiving $25,000 per year in benefits and are earning $40,000 per year in other retirement income, your combined income is $12,500 + $40,000, or $52,500.

Here's how much of your benefits may be subject to taxes depending on your combined income:

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Percentage of Your Benefits Subject to TaxesCombined Income if You're Filing Taxes as an IndividualCombined Income if You're Married and Filing Taxes Jointly
0%Less than $25,000 per yearLess than $32,000 per year
Up to 50%$25,000 to $34,000 per year$32,000 to $44,000 per year
Up to 85%More than $34,000 per yearMore than $44,000 per year

Source: Social Security Administration.

Keep in mind that these tax rates are only for federal taxes, and some states will make you pay state taxes on your benefits as well (although 37 states don't tax Social Security benefits at all). By being aware of what you may pay in taxes on your benefits before you retire, it can help ensure your retirement plan is as accurate as possible.

3. Not understanding what tax bracket you're in

Assuming you'll need to pay taxes on your retirement account withdrawals, the exact amount you'll owe depends on your tax bracket.

Income taxes are the same in retirement as they are when you're working, but the difference is that in retirement, you get to choose how much income you're earning. You can withdraw however much you want from your retirement fund each year, and that amount determines what tax bracket you fall under. If you're spending roughly the same amount in retirement as you were when you were working, you likely won't notice much of a difference in your tax bill. But if you decide to splurge during your first few years of retirement and withdraw a lot of cash, you may push yourself into a higher tax bracket.

There are a couple of things you can do before you retire to ensure your taxes don't get out of control. First, make sure you understand what tax bracket you'll be in when you retire. That will impact how much you pay in income taxes each year, which then affects how much you actually have to spend.

Second, adjust your withdrawal strategy so you stay within your desired tax bracket. It's smart to have a withdrawal strategy when you retire so you don't blow through your savings too quickly, but it can also help limit what you pay in taxes. Spending even a few thousand dollars over your bracket will result in a heftier tax bill, which can potentially throw off the rest of your retirement plan.

Taxes aren't the most exciting part of planning for retirement, but they are a vital aspect of your retirement plan. And the more accurately you account for them, the more financially secure you'll be in your golden years.

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