Tax Planning Strategies for Retirees to Save All Year

The great myth of income tax is that it’s a chore that runs from February to April each year. But saving real money on your income tax means taking action before the end of the year, especially for retirees. We know this year’s almost over, but even if you can’t do a lot to change 2021, you can start making plans for the new year. Here are five ideas for lawfully reducing your income tax in 2022.

1. Adjust Your Withholding

It’s important to get your withholding right: the IRS says your tax liability is on a pay-as-you-go system, and if you don’t pay enough during the year, you could be subject to an underpayment penalty. 

During our working years, most of us have our income tax withheld by our employers. Or, if we were self-employed, quarterly income tax payments were a part of our routine. Either way, most of our income, and tax withholding, came from one place.

In retirement, things are different: income might be coming from Social Security, a pension, distributions from retirement accounts IRAs, 401(k)s and 403(b)s, and the investments you sell. 

For the most part, we like to see each income source pay for its own income tax. You can have federal and state income tax withheld from pension income and retirement account distributions—contact the payer or investment custodian to find out how (it’s usually pretty easy). Social Security isn’t as flexible: if you choose to have them withhold federal income tax, it’s one of four percentages they specify. And they won’t withhold state tax at all (although only 13 states impose any tax on Social Security).

2. Schedule Your Estimated Payments

What about paying tax on income where there isn’t any withholding, like the gains from investments you sell? You have to account for any tax on that income either by increasing withholding from another income source or by making quarterly estimated tax payments. (This is what self-employed people do in lieu of an employer withholding tax from a paycheck.) Estimated taxes are often unfamiliar to new retirees, and it’s not as straightforward as it might sound. 

Your tax advisor can help you figure out if you need to pay quarterly estimates and how much they should be. One trap for the unwary: When it comes to estimated tax payments, Congress has a weird idea of what a quarter is: payments are due on April 15, June 15, September 15, and January 15 (based on income through the end of the previous month). So, quarterly payments can be based on periods from two to four months, but most taxpayers plan to pay equal dollar amounts throughout the year.

3. Schedule Your Required Minimum Distributions (RMDs)

Once you reach age 72, you have to begin taking annual RMDs from your traditional retirement accounts. The first RMD must be taken by April 1 (not April 15) of the year after you turn 72; every subsequent RMD, including for the year you turn 73, must be taken by December 31. (So, if you do wait as long as possible to take that first RMD, you’ll be taxed on two payments taken during the year you turn 73.)

What if you don’t take an RMD on time? The IRS calls this an excess accumulation, and the tax code imposes a penalty of 50% of this amount (the amount that should have been distributed but wasn’t). It’s often pretty simple to have this penalty waived for reasonable cause, but it does require filing an additional tax form, increasing the cost and complexity of your return. And repeated failures to take your RMD would probably reduce the chance of a waiver.

4. Use Your IRA For Charitable Contributions

If you’re charitably inclined and you’ve reached age 70½, you can reduce your tax bill by making your charitable contributions directly from your IRA. Using a Qualified Charitable Distribution (QCD), your IRA custodian follows your instructions to make a check payable directly to the charity. Not only is this amount excluded from income tax, it also counts toward your RMD for the year. (If you’re not yet subject to RMDs, it reduces your IRA balance—without taxation—thus reducing your future RMDs). 

Keep track of your QCDs so you can be sure to tell your tax preparer about them—up to now, the Form 1099-R doesn’t show whether a distribution is, in fact, a QCD.

5. Smooth Out Your Income from Year to Year

Often, tax planning is about more than just this year. The overlap of earnings with pensions, the onset of RMDs, the sale of assets, and even the maturity of US Savings Bonds can all cause spikes in taxable income that can push you into a higher bracket. A multi-year tax strategy can help you flatten the curve on your income, using strategies to lawfully manage the timing of income or deductions. While nothing is perfectly predictable—especially the tax code—your financial planner can help you evaluate strategies that are the most likely to benefit you in the long run.

Income tax is a special type of expense. Of course, it’s required by law. But if you can legally reduce it, you don’t have to give up anything (you’ll still have the same number of highways and parks). To get the most out of tax planning, it pays to look ahead. Remember, tax filing season may end on April 15, but tax season runs all year long. With this important understanding, you and your planner, working together, may be able to save you many thousands of dollars in income tax liability.

-Ken Robinson, JD, CFP^®

Want to save the most you lawfully can on your income taxes? Talk with us about tax planning.

Copyright © 2021 by Practical Financial Planning, Inc.