Whether you are just easing out of the workforce, or you have been retired for a few years, making the right financial moves is critical to creating a successful retirement plan. One of the most critical financial moves in retirement is tax planning.
Methods to help reduce your tax burden exist in many cases, but usually, this requires proactive action and planning beyond filing your tax return during tax season. Below we will outline six strategies you can utilize throughout the tax year to help minimize your tax obligations in retirement.
What you will learn:
- Take your required minimum distributions
- Manage your income combinations
- Figure out if you need to pay quarterly taxes
- Roth conversions
- QCD – Qualified Charitable Contribution
- Consider a tax friendly state
TIP #1: TAKE YOUR REQUIRED MINIMUM DISTRIBUTIONS
A required minimum distribution (RMD) is the amount of money that must be withdrawn from your retirement account each calendar year to comply with Internal Revenue Service (IRS) regulations. These required withdrawals begin when the retirement plan account owner reaches age 72 (separate rules apply for Inherited IRA accounts). The rules apply to employer-sponsored retirement plans, traditional IRA plans, and ROTH 401(k) accounts. However, these rules do not apply to Roth IRAs while the account owner is still alive.
Some IRA custodians and retirement plan administrators might help calculate and determine what your required minimum distribution is for you, but the ultimate responsibility lies with you. Suppose you do not withdraw the designated RMD (or the correct amount). In that case, the amount you fail to withdrawal will be taxed at 50 percent. This is why it is critical to take your RMDs and withdraw the correct amount.
It is also important to note that the percentage of your account you need distribute will grow larger each passing year. By the time you reach you mid-80’s, you will be required to withdrawal between 6-7% of your account depending on your age. The additional taxable income created by RMDs can cause some retirees to pay more in taxes and have higher income during retirement than when they were still working.
TIP #2: MANAGE YOUR INCOME COMBINATIONS
As a retiree, a portion of your income will likely come from Social Security benefit distributions. However, not all your benefits are taxable to you. There are ways to minimize or, at times, eliminate taxes on your Social Security benefits.
If half of your Social Security benefits in addition to your other income is higher than the base amount for your filing status for tax purposes, your benefits will be taxable. A maximum of 85% of your Social Security benefit is taxable by the IRS based on your total income. By strategically managing all your income sources, it is possible to lower the portion of benefits that will be taxed.
Retirees who have money in various types of taxable and nontaxable accounts can achieve significant tax savings depending on how assets are withdrawn. For example, suppose an individual finds themselves close to moving into a higher tax bracket due to a retirement fund distribution from a tax-deferred account. In that case, additional withdrawals can be taken from Roth accounts or possibly taxable (i.e. brokerage) accounts to avoid moving to the higher tax bracket.
Another cost that can occur due to high income in retirement is the Medicare surcharge. The Medicare surcharge is an additional fee people are required to pay for Medicare Parts B and D if their adjusted gross income is higher than $91,000 for person filing single or $182,000 for people filing married filing jointly. The additional fee is paid monthly per person and the amount is based on what income tier you fall in.
These are some of the reasons it is important to have diversity in the types of accounts you have. Having accounts where income and distributions are taxed differently will provide greater flexibility in income and tax planning.
TIP #3: FIGURE OUT IF YOU NEED TO PAY QUARTERLY TAXES (IF NOT, YOU MAY DECIDE TO DO IT ANYWAY)
As a W-2 employee, one of your employer’s obligations was to have taxes withheld from each paycheck. These withholdings were typically sufficient to meet your minimum tax obligations until your final tax return was filed, at which point you would receive a refund or have a balance owed.
If you do not have taxes withheld automatically, you may need to pay estimated tax payments. Individuals expected to owe $1,000 or more, or those whose withholding and refundable credits are 1) less than 90 percent of the tax owed or 2) at least 100 percent of the tax on the previous year’s return, must pay estimated tax. Failure to do so could result in significant interest and penalties.
Wage income is not the only type of income you should consider when making quarterly estimated payments. Income from interest, dividends, capital gains, rental income, retirement distributions, and Social Security benefits should also be incorporated into your calculation.
If your income from these sources is irregular or varies significantly between quarters, it is crucial to evaluate your potential tax obligations quarterly. A tax professional can help you forecast any potential tax obligations based on your unique circumstances.
Each state has its regulations surrounding minimum tax payment requirements and the type of income that will be taxed. Be sure to include this calculation when determining your total tax obligation.
In some cases, you might decide to pay quarterly taxes, to avoid the inconvenience of paying a large sum all at once. If you miss a payment or underpay, you may be charged a penalty.
TIP #4: ROTH CONVERSION
As noted earlier, Roth accounts can be a part of a long-term income withdrawal strategy to meet your income needs while also seeking to minimize taxes. As distributions from a Roth account are nontaxable, you can withdraw funds from this source to avoid moving to a higher tax bracket.
But what happens if you do not have Roth account funds available? A Roth conversion could be a viable solution.
What is a Roth Conversion?
A Roth conversion occurs when you take all or a portion of a traditional IRA or 401(k) balance and convert it into Roth account funds.
How Does a Roth Conversion Take Place?
A Roth conversion occurs by rolling over the assets from the traditional IRA or employer-sponsored retirement account into a Roth IRA or Roth 401(k) account. Taxes owed on the conversion are due in the tax year in which the conversion applies.
Is a Roth Conversion Right for My Situation?
A Roth conversion makes sense in cases where you feel that your (or your heirs) future tax liability will be higher than your current tax obligations. This is because any money that is put into a Roth account can be withdrawn tax-free. When your heirs inherit a Roth IRA they can withdrawal the money tax-free as well.
TIP #5 – QCD – Qualified Charitable Contribution
If you give money to charity, qualified charitable distributions can be a way to not only support your favorite charitable organizations but also save money on taxes.
Ordinarily, when you contribute to a qualified charitable organization, you give cash or property. For individuals who itemize their deductions, you can typically deduct up to 60% of any cash gifts on Schedule A of your tax return. Property gifts can be deducted at a smaller percentage depending on the type of property donated.
How Does a Qualified Charitable Distribution (QCD) Work?
For qualified charitable distributions, taxpayers may use payments from certain IRA assets to make the charitable contributions if the taxpayer meets specific requirements:
- Taxpayers must be at least 70 ½ to qualify for qualified charitable distributions (QCD).
- The funds must be distributed directly to the charitable organization from your IRA custodian.
- The maximum that can be donated to a charity via a qualified charitable distribution is $100,000 across all charities per year.
- To meet the eligibility requirements to qualify as a required minimum distribution (RMD), the payment must be issued by December 31st of the applicable calendar year.
- Payments made above the required minimum distribution amount do not roll forward to the next calendar year.
Qualified charitable distributions can be a strategy to contribute to charitable organizations that you support while also meeting required minimum distribution payment obligations for your retirement accounts. As with all tax rules, the rules on QCDs can change. This is why consulting a tax professional is important before implementing this strategy.
TIP #6: CONSIDER A TAX-FRIENDLY STATE
If you have been considering a change of scenery once you retire, moving to a state with low- or no-income taxes can provide significant savings over time.
There are currently nine states that do not assess a state income tax, including:
- New Hampshire
- South Dakota
- Washington, and
It should be noted that New Hampshire does not tax investment earnings.
Savings from living in a state without an income tax can be significant, especially when compared to high tax states such as California and New York where the top income tax rates are 13.3% and 8.82% respectively for high income earners. You should be aware that other taxes and expenses might be higher in states with no state income tax. Examples of other expenses to check out are housing expenses, property tax, sales tax, and healthcare costs.
Protecting your wealth through tax planning is crucial to ensuring that your financial assets are available throughout your retirement. It is important to continually have the assistance of a tax professional when making tax plans since tax laws are added, updated, and removed regularly. It is common that a tax planning method you used one year may not work the next.
👉 If you would like to get a FREE retirement assessment, click the link to schedule your 20-minute call to start the Retirement Assessment process.