It’s always a relief when tax season is over. But then again, tax season is never over.
You may leave behind a lot of things when you retire, but your tax burden isn’t one of them. In fact, taxes can potentially be an even bigger burden in retirement. The keys to avoiding that problem are awareness and planning. We’re going to share some things that could help you ‘Minimize Your Retirement Taxes.”
First, let’s talk about how different sources of retirement income are taxed.
Let’s start with the good news. If your only source of retirement income is Social Security, you probably won’t pay any taxes. That’s because Social Security income – by itself – is tax exempt. Now for the bad news. If you’re like most people, Social Security won’t be enough. You’ll need other sources of income, which means a portion of your Social Security income probably will be taxed. As for how much will be taxed, it varies, but it can run as high as 85 percent. For example, you’ll probably pay that 85 percent if you get large monthly income payments from a pension. As for the pension itself, most are funded with pre-tax income. If that’s the case, it means all of your pension income is taxable each year. However, if a portion of your pension was funded with after-tax dollars, then only a portion of the income will be taxed.
As for investment income from interest, dividends, or capital gains, naturally you’ll have to continue paying taxes on that just like you did before you retired. Now, what if your strategy is to systematically sell investment shares to generate retirement income? In that case, each sale would also generate a long- or short-term capital gain or loss, which you would need to report on your tax return. I should also point out that in most cases, this is a very bad strategy. For most people, your main source of retirement income besides Social Security is the money you have in your 401(k)s and IRAs. Those accounts are tax-deferred until you start taking withdrawals, which the IRS forces you to do starting at age 72 to satisfy your required minimum distributions. Your RMDs are unavoidable even if you have plenty of income from other sources. That makes having the right plan to satisfy your RMDs one of the most important parts of retirement planning and minimizing your tax burden is only one reason why. I’ll talk more about that later.
Now, let’s bring you up to speed on some important tax law changes.
In 2019 Congress passed the SECURE Act, the most significant piece of retirement legislation in years. It included several key changes that affect tax strategies. One of the biggest changes was raising the age for taking your first required minimum distribution from 70-and-a-half to 72. That gives you an extra year-and-a-half to grow your retirement accounts tax-free. The age is expected to rise higher over the next decade under the SECURE Act 2.0, which has already been approved by the House Ways and Means Committee. If signed into law, the SECURE Act 2.0 will raise the RMD starting age to 75 by 2032. It will also expand several other provisions already in place under the original SECURE Act. That bill did the following:
In addition, the income ceiling for Roth IRAs went up under the SECURE Act, which was the only real change to affect Roth IRAs. Does that make a Roth IRA a potentially better or worse tax tool than a traditional IRA? I’ll talk more about that and much more with Jeff in just a moment.
Now, let’s cover one of the biggest tax-related mistakes to watch out for.
As mentioned, if approved by the House, the SECURE Act 2.0 will further raise the age when required minimum distributions kick in from 72 now to 73 next year, 74 in 2029, and 75 by 2032. Although that gives you more time to grow your retirement accounts tax-free, it doesn’t mean you should put off preparing for your RMDs. I want to stress again that your RMD strategy is one of the most important elements of your retirement plan, and having the wrong strategy is one of the most common mistakes retirees make with their money. It’s also one of the costliest, and the extra tax burden it creates is only one reason why. RMDs start at almost 4 percent of your IRA balance and increase each year as you get older. If you don’t calculate them correctly, the IRS may slap you with a 50 percent penalty. However, even if you do calculate them correctly, it’s just as important to have the right asset allocation to satisfy your RMDs without running the risk of spending down your principal. In my experience, that means an allocation that can generate at least 4 percent dividend or interest. If you’re earning less than that, you may be at risk of cannibalizing your principal to satisfy your RMDs, which is an even bigger problem than the larger tax burden you might incur.
Now, let’s look at a few tax-saving strategies you might be able to use every year once you’ve reached retirement age.
For many people, a quick and easy strategy is to simply take advantage of the higher standard deduction offered by the IRS to taxpayers 65 and older. Single filers in that age group were able to increase their standard deduction by $1,700 dollars in 2021, and joint filers by $2,700. As you may know, you need to have more tax deductions than the standard deduction to make itemizing your return worthwhile, and even then, the standard deduction might still make more sense. Another strategy that might work for you involves spousal IRA contributions. Even if you’re no longer working but your spouse is, he or she can contribute up to $7,000 dollars a year to an IRA that you own. As long as your spouse has enough earned income to make the contribution, this tax shelter remains open to you.
Speaking of work, if you become self-employed after you retire – say, as a consultant – you can deduct the premiums you pay for Medicare Part B and Part D on your taxes. Another popular strategy is to have any payout you receive from a pension, annuity, or other source sent directly to a rollover IRA instead of to you. As long as the check is made out to the account instead of you personally, you’ll avoid the automatic withholding required by the IRS. Again, these are just a few strategies that may or may not be right for you, depending on your situation and retirement goals.
If you’re like most people, you don’t enjoy thinking about taxes, and you certainly don’t look forward to tax season. But like with so many unpleasant things in life, ignoring your taxes can make them even more unpleasant and increase the financial burden they create. That’s especially true when you’re retired or getting close to retirement when smart, proactive financial planning is more important than ever. The right advisor can help you create the plan that’s just right for you. One that helps to minimize your tax burden and helps ensure you can enjoy retirement with greater peace of mind and the reliable income you need to meet your needs and achieve your goals.
Are you concerned with how COVID can affect your retirement? Check out our previous show at the link below.
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