The transition from employment to retirement can be complex. For decades, employees and business owners received either a regular paycheck or earnings from self-employment. Suddenly, that will slow or stop. Not only will cash inflow stop, but you will also be taking money out of all these accounts. For many people who have put so much effort into saving, it may be hard to start spending down their nest egg.
Retirement-related behavioral and financial changes raise many tax planning questions and opportunities. Let’s walk through the most common concerns for impending retirees and strategies to address those concerns. A trusted tax professional can help you implement these and other strategies to help you minimize taxes in retirement, helping your money last longer and you realize your goals.
Common Concerns in Retirement
- How much of your Social Security benefits will be taxable
- How to plan for post-retirement and pre-RMD age years (income timing)
- How to plan for tax and income changes when you become a widow
- How and when to decide whether to convert Roth account savings
- How to use deduction “bunching” to help optimize tax savings by annually alternating itemized deductions with the standard deduction
- How much your state taxes could impact your retirement
Taxability of Social Security
How much of your Social Security benefits will be subject to tax is calculated based on your provisional income and filing status. Provisional income is your adjusted gross income PLUS tax-free interest PLUS 50% of gross Social Security benefits.
- Taxpayers filing as single with provisional income less than $25,000 and taxpayers filing joint returns with provisional income less than $32,000 do not pay federal income tax on their Social Security benefits.
- Taxpayers filing as single with provisional income between $25,000 and $34,000 and taxpayers filing joint returns with provisional income between $32,000 and $44,000 pay federal income tax on up to 50% of their Social Security benefits.
- Taxpayers filing as single with provisional income greater than $34,000 and taxpayers filing joint returns with provisional income greater than $44,000 pay federal income tax on up to 85% of their Social Security benefits.
Social Security was designed to supplement personal savings and income from various retirement savings vehicles. It was not intended to be most individuals’ only source of retirement income. However, some people have not had or not taken the opportunity to save on their own, and guaranteed retirement pensions are becoming an endangered species, replaced by other plans like 401(k)s.
For many individuals, Social Security does become their only source of income in retirement. If Social Security is your only source of retirement income, none or very little of it will be taxed. If, however, you are expecting additional income in retirement, either 50% or 85% of your Social Security income will be taxable. Note that this is the portion of your Social Security income that will be taxable, not the tax rate on the Social Security income itself.
Without proper planning, retirees might also encounter the “tax torpedo.” The tax torpedo occurs when retirees realize additional income that increases the percentage of Social Security income that is subject to tax. Examples of this occurring include:
- Beginning to take required minimum distributions.
- Incurring larger capital gains or other portfolio income.
- Needing to take a large, unplanned distribution from a retirement account to pay for an unexpected expense.
Annual tax planning with a year-round tax professional can help to both determine and plan for how much of your Social Security income will be taxable each year.
Can You Time How Much Income to Recognize Each Year?
Taxpayers encounter two types of income in retirement: fixed (Social Security, pensions, annuities) and variable (investment accounts, traditional and Roth IRAs, 401(k) accounts).
The wonderful thing about fixed income is that it is a consistent income source; the downside is that it limits the available tax planning options.
Variable income, on the other hand, allows for income timing and tax planning opportunities such as:
- Roth conversions
- Qualified charitable distributions (QCDs)
- Tax gain or tax-loss harvesting
Your tax professional can help you find the best strategies for your situation. The important thing is to plan for these strategies before the end of the year in which you want to implement them. If you wait until tax season to talk to your tax professional about planning opportunities, the advantages will not be useful for your prior year’s tax period.
For most tax advisors and financial advisors, the ideal time for tax planning is early in the year—even if most strategies won’t be implemented until October or November. This gives the professional a good estimate of your income early in the year. It also gives them time to provide you with information, explanations, and recommendations before the tax year ends and account for any deviations to your plan.
If you have a small business that will continue into retirement, it’s important to time your business income and expenses in a tax-efficient manner. For example, you can build extended payment due dates into your contract if you want the option to recognize business income in the following year. Or you may want to purchase equipment and incur other expenses to lower income in a specific year.
Planning for Widowhood
While it may seem hard to discuss, planning for the loss of your spouse is important. The U.S. Census Bureau reports that widowhood is more common among older women than among older men because of the differences in life expectancies. Among those 75 years and older, 54% of women were widowed at the time the research was conducted, versus 20% of men.
Planning for the transition from joint to single filing is important. Tax rates become more condensed at the single filer rate. It is important to not over- or under-withhold on taxes in the year of your spouse’s death and the subsequent years.
For example, a married couple who files jointly might be in the 12% or 22% tax bracket. When one spouse passes away—unless there is a corresponding reduction in income—the surviving spouse could jump at least one marginal tax bracket because the income brackets are different for single individuals.
It may be possible to adjust variable income to reduce some of the additional tax burden as discussed above. Of course, adjusting income will also depend on expenses such as mortgages, property taxes, medical bills, food, utilities, etc. Though you might be tempted to avoid a difficult conversation, remember that forewarned is forearmed.
Benefits of Roth Conversions
On average, taxpayers with some retirement savings have more money saved in traditional tax-deferred accounts than in Roth accounts. The reason behind this is that people are typically in a higher tax bracket when they work than they will be in retirement. The downside is that exceptional savers with positive investment returns can find themselves in a higher tax bracket in retirement than they were when they were working, especially once the RMD requirement kicks in.
Properly calculated and timed, Roth conversions can help taxpayers with large balances in traditional tax-deferred accounts reduce their long-term taxes by paying a finite amount of taxes in the short term.
A Roth conversion is when a taxpayer transfers a specified amount of money from a traditional tax-deferred retirement account into a Roth account. The taxpayer pays tax on the converted amount in the year of the conversion because it is treated as a distribution from a tax-deferred account. Placing the money into a Roth account now allows that money to grow tax-fee with the intent that when it is distributed, no tax bill is attached to it if certain criteria have been met.
It is important to model approximately how much the taxpayer should do in Roth conversions so as not to overdo it. Most financial planning software will have a break-even analysis to help calculate if and how much is worth doing. Converting to a Roth has the additional benefit in that the taxpayer’s heirs will inherit the account and not be subject to tax on distributions—so long as the criteria for the Roth account have been met.
Conversely, if a Roth conversion does not make sense, some people may want to consider spending down their accounts before their RMD age. That way, the tax-deferred account balances start to deplete while leaving taxable brokerage accounts untouched, allowing a step-up in basis on more of your assets at death.
Can Bunching Allow You to Take Advantage of Itemized Deductions?
I always start this discussion by asking whether the taxpayer is charitably inclined and if they have a mortgage. While those two items sound disconnected, they are linked in their function in the tax code. They help determine whether or not a taxpayer could itemize their deductions or whether it is more beneficial to use the standard deduction.
When it comes to realizing the benefits of itemized deductions, four factors are usually key:
- Taxes paid to state and local governments
- Real estate and property taxes
- Mortgage interest paid
- Charitable contributions
Under current tax law, there is a $10,000 cap on the amount of state and local taxes (SALT) that can be deducted. Consequently, for taxpayers who are not charitably inclined, the item most likely to determine whether or not they will benefit from itemizing their deductions is the amount of their mortgage interest. For the more philanthropically inclined, however, a combination of mortgage interest, SALT, and charitable contributions could allow the taxpayer to itemize their deductions.
If a client is falling short of the standard deduction, they may want to consider a strategy called bunching. If taxpayers bunch enough charitable contributions into one year, it could allow them to realize the benefits of itemizing their deductions for that year. Of course, to be of any benefit, the total amount of contributions, mortgage interest, and SALT-capped deductible taxes needs to be more than the standard deduction amount.
The bunching strategy works best when the taxpayer typically makes large donations to their charities of choice. And it is recommended that the donor discuss this strategy with the recipient so that the recipient understands that the average annual donation will remain the same but that they will only receive the money every other year.
Alternatively, taxpayers can consider using a donor-advised fund (DAF). The irregular donation is made to the DAF, which is a legal nonprofit organization, and the taxpayer deducts the amount of the donation in the year it is made. The taxpayer can then direct which charities the DAF will fund annually and how much each is to receive. This can help charities maintain a more even cash flow year-to-year while the taxpayer recognizes the tax benefit of the contribution.
What About State Taxes?
One last thing to keep in mind is state taxes. Some states do not have income tax, and others do not tax or partially tax retirement income. Generally, state taxes are lower than federal taxes, but they are still important to plan for.
If you are someone who lives in multiples states or plans to move, it is important to speak to a tax professional or your financial advisor about the tax implications. You will want to stay in compliance with the states and not miss out on any tax planning opportunities.
Work with a Tax Professional
Proper and early tax planning helps allow you to not have any surprises on your tax return. Working with a trusted tax professional can often help you to understand both the sources and amounts of your retirement income and how that income will be taxed. A good tax professional can also provide planning strategies that will help to minimize your taxes as you transition to retirement and throughout your life as a retiree.
Your tax professional can help you become and remain the boss of your taxes.
Ryan Egolf is a non-registered associate of Cetera Advisor Networks, LLC.
For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give legal or tax advice.
Sources: https://www.congress.gov/crs-product/IF11397
Distributions from traditional IRAs and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59 1/2, may be subject to an additional 10% IRS tax penalty.
A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 1/2 or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.
Converting from a traditional IRA to a Roth IRA is a taxable event.
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