Taxes in Retirement
There are two things in life that are unavoidable: death and taxes. Taxes are viewed as being overly complex but saving money through the reduction of taxes doesn’t have to be difficult. Reducing taxes and keeping more of your hard earned money can substantially impact your future position in retirement and provide a sense of relief. I say this because many of my clients have a fear of outliving their money, so employing strategies to keep more of it should be their top priority. Throughout this writing we will cover different strategies that you can take to protect more of your money.
Key Takeaways:
· Tips for reducing your taxable income and more
· Lowering your federal income to avoid taxation
· Why it’s helpful to delay drawing from Social Security
· Living in a tax friendly location
· What to do with inherited funds and property
Tips for Reducing your Taxable Income and More
When you are employed, you will pay federal income tax, state income tax, payroll tax (Social Security & Medicare), and potentially a local tax. Although, if you are fully retired then you will no longer need to pay the payroll tax. Keep in mind, there are other taxes such as property, sales, and car tax, but we will start with the taxes that you will be subject to on distributions from your retirement accounts and social security.
Starting with federal income tax, the amount you pay will be determined by where your retirement income is coming from. If those distributions out of your retirement accounts are pre-tax money, then they are considered taxable income and will be taxed as ordinary income. To contrast, any Roth accounts will not be subject to taxes as distributions are tax-free (not part of your taxable income) if you are over age 59.5 and have had the account open for over 5 years.
Pensions are becoming less common for non-government employees, but retirees today have corporate pensions that were likely acquired in the final years they were available. If you have a pension, then the monthly benefit that you receive is going to be taxed as ordinary income.
Social security depends on your income, and the amount of income that is taxable is dependent on your filing status whether that be single, joint, or married-filing separately. Those who pay taxes on their Social Security benefit typically have high income in addition to their Social Security benefit. If you are single and your “combined income” is between $25,000 and $34,000 then you may have to pay income tax on up to 50% of your Social Security benefit while those over $34,000 will have to pay income tax on 85% of their Social Security benefit. Of course, if you are married then the combined income is allowed to be larger as it includes two income sources and expenses.
If you and a spouse have combined income between $32,000 and $44,000 then you may have to pay income tax on up to 50% of your benefit and those with combined income over $44,000 will pay income tax on 85% of their benefit. The term combined income is calculated using a formula provided by SSA.gov which is Adjusted Gross Income + Nontaxable Interest + ½ of your Social Security benefits = Combined Income. To investigate the formula and its breakdown further, you can follow the link to the page on SSA.gov. This is valuable because each January you are going to receive a Social Security Benefit Statement (Form SSA-1099) that shows the amount of benefits you received the preceding year to determine if your benefits are subject to tax.
Lowering your Federal Income to Avoid Taxation
Federal income tax is the largest tax that residents have to pay, and the difference in percentage to be paid is dependent on what tax bracket you fall under. For single filers, the 12% tax bracket is for annual income between $11,001 and $44,725, while the bracket for joint filers is between $22,001 and $89,450. If either type of filer has taxable income above the upper limit, then the federal income tax increases to 22% which is a significant increase. If you are just over the upper limit, then there are strategies you can employ to bring your taxable income under the limit and save yourself 10% in taxes. For many, this can be accomplished through taking smaller distributions or delaying your social security.
Dividend income and long-term capital gains are both taxed at a maximum rate of 20% which is taxed at a lower rate than interest and short-term capital gains. Therefore, if you have taxable money outside of your retirement accounts then you should consider holding mostly stocks or mutual funds that pay dividends. This way you would pay a maximum of 20% in taxes, versus being taxed as ordinary income for short-term capital gains interest from CD bonds and savings accounts (added to taxable income). If you had a choice of where to keep your conservative money (bonds, CD’s) then you’d want to put them in your retirement accounts because that way the taxes are deferred and you’re not paying taxes on the interest.
Why it’s Helpful to Delay Drawing from Social Security
Another strategy to reduce taxes would be to delay your Social Security benefit to age 70. The benefit of doing so is that it will require you to take money out of your retirement accounts, which will reduce the amount you need to take out (RMD’s) once you begin to collect Social Security. Therefore, the timing of these distributions and Social Security should be a key planning topic as when done correctly, it can substantially reduce your taxes in the future. A financial planner is a great resource to help you plan your RMD’s, so if you would like assistance in doing so then follow the link and set up a free retirement assessment.
A required minimum distribution (RMD) refers to the amount that must be withdrawn from an employer-sponsored retirement plan such as a 401(k), or a traditional IRA, SEP, and simple IRA by participants of retirement age. Account holders must start taking RMD’s by April 1st following the year the individual turns 73, with the deadline of December 31st every year after that. The consequence for not correctly taking your RMD is a 50% tax on the amount that was not withdrawn which is why I’m stressing the importance of creating a plan. The IRS has a worksheet to assist taxpayers calculate the amount they must withdraw each year, which could serve as a placeholder in planning until the exact amount is calculated.
Another idea is to convert part of your 401(k) or IRA into a Roth IRA which would serve the same general purpose. Transferring retirement funds into the Roth IRA works to your advantage because Roth IRA’s do not have RMD’s. Doing so will reduce the size of your RMD’s as you will be pulling from a reduced total value in your retirement accounts. This will limit the chances of your RMD’s pushing you into the next tax bracket now and in the future as you drawdown these accounts.
Living in a Tax Friendly Location
State tax is another important factor to cover as where you live could significantly impact the amount of taxes you pay each year. All U.S. States are different as some have income tax while others do not, and then certain states tax retirement accounts and pensions differently, etc. and it’s all important information to know. States such as Florida, New Hampshire, and Tennessee do not have income tax which eliminates one of the larger taxes that residents of the US pay, so it makes sense why retirees like Florida. A great resource to investigate each State’s tax laws is a heat map created by Kiplinger that displays the states ranked from most tax-friendly to least-tax friendly. There are five different levels, and you can see a detailed breakdown of the taxes in each State by clicking on the State you are interested in.
Keep in mind, State governments must make money so even if there is no income tax, there is likely another tax that the state uses to bring in its revenue. An example would be New Hampshire as they have no How are the taxes in your state of residence? income tax, but what they do have is the fourth highest property tax in the United States. As mentioned above, States also have different tax procedures when it comes to retirement accounts, pensions, social security, and property so depending on your income sources and property value residence in certain States would benefit you more than others.
If you are thinking about moving and it makes sense for you then I would suggest looking into States with no state income tax. From there you would want to investigate further looking into housing costs, property taxes, sales taxes, etc. There are other factors to consider as well like the culture, crime rates, and if you will have to move far away from family and friend so make sure to consider more than just the monetary aspects. Lastly, this would have to be your primary residence which the IRS considers to be the residence you live in at least 6 months per year.
This applies to citizens with two or more houses to prevent them from claiming primary residency in whichever State that would require less taxes. For this reason, the IRS is aggressive in determining which residence you spend most of your time in. This is especially true for residents of high-tax states such as Connecticut and New York because their additional properties are commonly located in more tax-friendly States. The IRS will check your EZ pass, credit card receipts, and even phone records so understand that spending a few months in your Florida house will not be enough to claim it as your primary residence.
Another option is to move to a different country. This is less common, but there are many countries where the cost of living is cheaper than the United States. Additionally, this could include better weather, less stress, and the potential for new experiences. The disadvantages would include moving away from friends and family, and potentially having to pay taxes twice if you’re still subject to United States income tax. Therefore, if you are thinking about moving outside of the United States then you should do extensive research and weigh the pros and cons of doing so.
What to do with Inherited Funds and Property
An area that people usually forget to consider is the tax you pay on inherited funds and property. These taxes do not necessarily come from the inheritance themselves, but rather the selling of these assets. Inherited assets could include stocks, bonds, real estate, art, collectibles, etc.
Let’s say you inherit stock from your parents, the cost basis is then stepped up to the price of the stock on the date you inherit it. When you decide to sell the stock, you need to make sure that it doesn’t push you into a higher tax bracket, so a common strategy is to sell it over time. This way your taxable income doesn’t increase by too much in any given year to protect you from paying additional taxes.
Taxes apply to any retirement account you inherit as well. The rule is that if you inherit a retirement account from anyone other than your spouse, then you will have ten years until that retirement account needs to be fully withdrawn. A general strategy is to sell more of the account in the years where you have lower taxable income to protect from being pushed into a higher tax bracket. Keep in mind, if you wait too long to start withdrawing from the account then you will not have as much flexibility when it comes to creating a plan to successfully drawdown the account with limited tax consequences.
Another thing you need to plan around is your income in relation to Medicare. If you are retiring at age 65 or later then you will have to enroll in Medicare and pay a Part B premium that is $164.90 monthly. If you are a single filer with a modified adjusted gross income above $97,000 or a joint filer with a modified adjusted gross income above $194,000 then you will have to pay a premium on top of that called the income related monthly adjustment amount (IRMAA). There are six different income ranges and IRMAA increases for each one after the first level. To learn more, check out this great chart on Medicare.gov to better understand the breakdown.
Keep in mind, the income that the government uses to calculate your income level is based on the prior two years. Which seems unfair, but there are ways to appeal the additional IRMAA fee if your income has changed in the past two years. Reasons for appeal include life changing events such as marriage, divorce, death of a spouse, work stoppage, work reduction, loss of income producing property, loss of pension income, and employer settlement payment. Although, if you haven’t experienced any of these events then you are not qualified to make an appeal and will end up paying the full amount.
A good example would be an individual who just retired. Assuming the individual’s income is significantly lower than when he was working, he would have grounds to an appeal on IRMAA due to work stoppage. It would be unfair to require a new retiree to pay the additional fee because the calculation used his income amount from when he was still employed. To learn more about IRMAA check out last week’s blog, “The 2023 IRMAA Brackets.”