5 Tax-Planning Tips for Retirement

It’s a common misconception about retirement: your tax bills shrink, your returns become simpler and tax planning is a thing of the past. That may be true for some. But many people find that the combination of Social Security, pensions and withdrawals from retirement accounts increases their income in retirement. In fact, it may even push them into a higher tax bracket.

If you’re retired or approaching retirement, consider these five tax-planning tips:

1. Take inventory. Estimate how much money you’ll need in retirement for living expenses, and inventory your income sources. These may include:

• Taxable assets such as mutual funds and brokerage accounts
• Tax-deferred assets such as IRAs, 401(k) plan accounts and pensions
• Nontaxable assets, such as Roth IRAs, Roth 401(k) plans or tax-exempt municipal bonds. (Social Security benefits may be nontaxable or partially taxable, depending on your other sources of income.)

Develop a plan for drawing retirement income in a tax-efficient manner, being sure to keep state income tax (if applicable) in mind. For example, you might minimize current taxes by tapping nontaxable assets first, followed by assets that generate capital gains, and putting off withdrawals from tax-deferred accounts as long as possible.

On the other hand, if you’re approaching age 72 and will have substantial required minimum distributions (RMDs) from tax-deferred accounts when you reach that age, it might make sense to withdraw some of those funds earlier. Why? It can help you avoid having large RMDs that would push you into a higher tax bracket later.

For instance, you might withdraw as much as you can from IRAs or 401(k) accounts each year without exceeding the lower tax brackets. That way, you keep current taxes on those funds at a reasonable level while reducing the size of your accounts. This in turn reduces the size of your RMDs down the road. You can obtain additional funds from nontaxable or capital gains assets if needed.

2. Consider the timing of Social Security benefits. You can begin receiving Social Security benefits as early as age 62 or as late as age 70. The later you start, the larger the benefit amount. So if you don’t need the money right away, putting it off may be a good investment. Also, benefits are reduced if you start them before you reach full retirement age and continue to work.

Remember, if your income from other sources exceeds certain thresholds, your Social Security benefits will become partially taxable. For example, married couples filing jointly with combined income over $44,000 are taxed on up to 85% of their Social Security benefits. (Combined income is adjusted gross income plus nontaxable interest plus half of Social Security benefits.)

3. Make qualified charitable distributions. You’re required to begin RMDs from tax-deferred retirement accounts once you reach age 72 (up from 70½ for people born before July 1, 1949). However, you’re able to defer your first distribution until April 1 of the year following the year you turn 72. RMDs generally are taxed as ordinary income, and you must take them regardless of whether you need the money. As noted in our first tip, a large RMD can push you into a higher tax bracket.

One strategy for reducing the amount of your RMDs is to make a qualified charitable distribution (QCD). If you’re age 70½ or older (this age didn’t increase when the RMD age increased), a QCD allows you to distribute up to $100,000 tax-free directly from an IRA to a qualified charity and apply that amount toward your RMDs.

The funds aren’t included in your income, so you avoid tax on the entire amount regardless of whether you itemize. In addition, the income-based limits on charitable deductions don’t apply. Any amount excluded from your income by virtue of the QCD is similarly excluded from being treated as a charitable deduction.

4. Pay estimated taxes. Your retirement income sources may or may not withhold income taxes. To avoid surprises (and penalties), estimate whether your withholdings will cover your tax liability for the year. Make quarterly estimated tax payments to cover any expected shortfall.

5. Track your medical expenses. Currently, medical expenses are deductible only if you itemize and only to the extent they exceed 7.5% of your adjusted gross income. If you have significant medical expenses, track them carefully. If you exceed (or are close to) this threshold, consider bunching elective expenses into the year to maximize potential deductions.

If you’re nearing retirement age and have questions on how your tax situation may change, contact your tax advisor.

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