Whether you’re just easing out of the workforce or you’ve been in retirement for a few years, it’s critical to make the right financial moves. One central goal during retirement is protecting your wealth from unnecessary taxes.
There are ways to avoid owing more taxes, but they usually require proactive attention beyond tax season. Here are four tips you can use throughout the year to help minimize your retirement tax obligations.
Tip #1: Manage Your Income Combinations
As a retiree, a portion of your income will likely come from Social Security. However, not all of your benefits are taxable, and there are ways to minimize or even sometimes eliminate taxes on your Social Security benefits.
Depending on your total income, 0%-85% of your Social Security benefits may be taxed.1 By strategically managing all your income sources (such as pension payments, dividends, or wages from work in retirement), it’s possible to reduce the taxed portion of your benefits. Take your state’s tax rules into account to determine the best solution for you—some states tax Social Security.
Tip #2: Smooth Out Your Tax Bracket
Many people’s income tax brackets can vary tremendously throughout their lives. For those in retirement, the swing from year to year can be quite large: we have seen instances where someone pays no tax early in retirement but will be in the 24% bracket once they start taking Required Minimum Distributions from IRAs. You can take advantage of your low-income tax brackets early in retirement by realizing capital gains on investments, strategically distributing money from your retirement accounts, or carrying out Roth conversions. (Learn more about Roth conversions: check out our recent article here.)
Tip #3: Watch Medicare Breakpoints
Medicare can charge an extra amount based on your income. This income-related monthly adjustment amount (IRMAA) isn’t phased in slowly; it jumps at specific amounts of adjusted gross income. So for some taxpayers, an extra $1 of income can increase their monthly Medicare premium by hundreds of dollars a year. Ask your tax advisor about these breakpoints, especially if you’re planning to smooth out your income from year to year.
Tip #4: Figure Out If You Need to Pay Quarterly Estimated Taxes
If you don’t have enough tax withheld from your income, you may need to make estimated tax payments. Individuals who expect to owe $1,000 or more in federal tax must pay quarterly estimates large enough that the total of withholding, timely estimates, and refundable credits equal at least:
1) 90% of the tax shown on the return or
2) 100% of the tax on the previous year’s return (110% if prior-year adjusted gross income was greater than $150,000 [$75,000 if the current-year return is filed Married Filing Separately]).2
If you’re late with a payment or underpay, you may be charged a penalty.
Tip #5: If You’re Moving to a New State, Get to Know Its Tax Laws
If you’re relocating to a new state in retirement, consider the impact of the move on your financial situation, as tax laws vary substantially state by state. For example, some states don’t tax income; others only tax dividends and interest. On the other hand, they may have higher property tax, sales tax, or estate tax than other states.
Tip #6: Take Your Required Minimum Distributions (RMDs)
An RMD is a specific amount that you are required to withdraw from your retirement account (your IRA, 401(k), etc.). These required withdrawals begin when you, the account owner, reach age 72. (There are no RMDs for Roth IRAs until the account owner’s death.)
Some IRA custodians and retirement plan administrators might calculate your RMD for you, but the responsibility ultimately is yours. To find out your RMD, the IRS provides life expectancy tables to use according to your circumstances. If you do not withdraw at least the proper RMD amount each year, the remainder of the RMD will be taxed at a whopping 50%.3
Most retirees have to work with a fixed amount of wealth to last throughout retirement, so taking the right financial steps is essential. Keep these six tips in mind so you and your advisor can make sure you’re not paying more tax than you need to. And if your plan includes gifts to your children or grandchildren, you can discuss additional strategies to reduce taxes with your financial planner.