Taxes in retirement can fluctuate drastically from taxes while working full time.
If you’re near retirement, you may be looking forward to the day when taxes get simpler. You could be disappointed.
Everyone’s tax situation is different, but here are 6 tax issues you may encounter and ways to lessen their impact.
Deductions May Disappear
If your children are grown and your house is paid off, you’ll no longer get tax breaks for dependents or mortgage interest. And you’ll no longer be able to get a tax break for contributing to a 401(k) or IRA, Slott says. Your deductions for charitable contributions may decline, too, as many retirees tend to volunteer more than donate. And starting with the 2017 tax year, taxpayers age 65 and older will be able to deduct only the amount of medical expenses exceeding 10 percent of adjusted gross income, up from 7.5 percent.
Solution: Take advantage of available tax breaks while you still can. Bunch up any elective medical expenses into one year to meet the higher health deduction.*
You may end up in a higher tax bracket
Many retirees drop into a lower tax bracket when they stop working. But after age 701/2, they must start taking minimum distributions annually from tax-deferred accounts such as a 401(k) or traditional IRA.
These distributions — on top of other income — can push retirees into a higher bracket. For example, singles with taxable income of up to $37,950 — or couples filing jointly with $75,900 — are in the 15 percent tax bracket this year. Throw in several thousand dollars from a required distribution, and that extra income will be taxed at 25 percent.
Also, avoid two distributions in the same year. Your first required minimum distribution is due by April 1 of the year after you turn 70 1/2. Your second and all subsequent distributions must be taken by Dec. 31 each year. If you delay your first distribution until April you will be required to take two distributions in the same year, which could result in an unusually high tax bill or even bump you into a higher tax bracket.**
Solution: Consider taking distributions from tax-deferred accounts while still in your 60s and in a lower tax bracket, experts say. With care, you can steadily withdraw money and stay within your current tax bracket. Or convert some tax-deferred dollars into a Roth IRA. You’ll owe income taxes on the amount converted, but thereafter Roth withdrawals are tax-free. And Roths don’t have required distributions.*
Your Social Security may be taxed
Many retirees are surprised to find that their Social Security benefits are taxable if their income is above a certain level. And it doesn’t take much income to trigger the tax.
Under the IRS formula, half of Social Security benefits are added to other income retirees receive. If the amount exceeds $25,000 for singles or $32,000 for married couples filing jointly, a portion of the benefits will be taxed.
Solution: Tapping tax-deferred accounts earlier in retirement will reduce future required distributions, and may provide the money to live on so you can postpone taking Social Security benefits. For every year up to age 70 that you postpone benefits beyond your normal retirement age (66 to 67 for most people), your benefits will increase 8 percent.*
You may pay taxes quarterly
Your employer withholds taxes from your paycheck and forwards the money to Uncle Sam. That’s not the case in retirement, so you may have to pay estimated taxes quarterly or face a penalty.
Solution: You may be able to avoid quarterly payments by asking your brokerage or former employer to deduct taxes for you from your IRA withdrawals or pension check, she says. Make sure the withholding is enough to cover your tax liability.*
Your finances may get more complicated
If you’ve been a good saver, you likely accumulated multiple accounts and need to withdraw that money in the most tax-efficient way.
Solution: Make this job easier for yourself by consolidating accounts. And just before retirement or during the first year, see a tax professional for advice.*
Tax-preferred or Tax-deferred?
Keep your tax-preferred investments outside retirement accounts.
Investments that generate long-term capital gains receive preferential tax treatment when held outside of a retirement account. However, if you put them in a retirement account, you will pay your typically higher regular income tax rate when you withdraw the money from the account. In contrast, you can lower your tax bill by holding more highly taxed investments, including Treasury inflation-protected securities, corporate and government bonds and funds that generate short-term capital gains inside retirement accounts. You normally push the equity portion into a nonqualified account, and then you push any income producing securities like bonds into the IRAs.**
If you don’t have a laddered income solution or would like to discuss how you could potentially pay less taxes in retirement, then email us to schedule a Strategy Session at info@commonfinancialsense.com.
P.S. Another relevant article can be read here How To Understand a Tax Efficient Distribution Strategy So You Can Pay Less Taxes in Retirement
*AARP March Bulletin 2017
Investment advisory services offered through Global Retirement Partners, LLC, an SEC Registered Investment Adviser. SEC registration does not imply any level of skill or training.
This material is for informational purposes only. It is not intended to provide tax, accounting or legal advice or to serve as the basis for any financial decisions. Individuals are advised to consult with their own accountant and/or attorney regarding all tax, accounting and legal matters.
