Retirement is the time in our life when we get to relax and leave the workforce behind. While we may get to relax from the daily grind, we still need to pay income taxes.
If you’re on a payroll, you may have seen a FICA tax deducted from each paycheck. FICA, or Federal Insurance Contributions Act, is a U.S. federal payroll tax that funds both Social Security and Medicare programs, providing benefits to retirees, the disabled, and children.
A question that comes up often is whether you pay Medicare tax on retirement income. After retirement, your source of income switches to investment income and retirement benefits, and you typically are not required to pay Medicare or FICA tax on most or all of your retirement income.
Investment Income and Medicare Taxes
After retirement, the majority of Americans rely on income from retirement savings, Social Security benefits, and pension benefits. While Social Security benefits are subject to income taxes after retirement, pension payments, annuities, and the interest or dividends you receive from your savings or investments are not subject to Medicare or FICA taxes.
For contributions that you’ve made to traditional retirement accounts, such as an IRA or 401(k), FICA taxes were paid when the money was earned and don’t have to be paid again when you begin making withdrawals. If your employer matches your contributions to your 401(k), the match is not subject to Medicare taxes.
Deferred compensation is a portion of an employee’s salary that is paid out at a later date. The income is not received right away, so taxes are not paid when this income is earned. Once you collect this income, even after retirement, it is then subject to income taxes, Medicare taxes, and Social Security taxes.
If you’re collecting deferred compensation after retirement, prepare for a hefty tax bill. Let’s say your employer puts aside $10,000 of your annual salary in deferred compensation. After 10 years, you leave the company and retire. The year you receive this deferred income, you’ll need to pay taxes on $100,000 of income.
There are different methods of structuring these payments instead of one lump-sum payment but it depends on the plan details.
A severance package is pay and benefits that an employee may be entitled to receive if they unwillingly leave a company. Severance pay is taxable, and if you receive payment from a severance package with a former employer, you must pay taxes on this income.
However, if the company files for bankruptcy and goes out of business, the Sixth Circuit Court rules in 2021 that severance pay in his circumstance is not subject to FICA taxes.
Working in Retirement
Your age doesn’t change whether or not you pay Medicare taxes. If you retire from your career at the age of 65 and decide to start working part-time, your income is subject to Medicare taxation. If you decide to start your own business, your FICA taxes will be higher. Self-employment FICA taxes are twice the regular rate because employers normally match the employee tax rate.
Before you retire, you should prepare for taxes by knowing what is subject to taxation and how much you may owe. Work with your financial advisor and a tax professional to start preparing.