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Retirement on the Horizon? Make Tax Planning a Priority

Jul 13, 2022

Many people assume they’ll enjoy the luxury of simple tax returns along with a lower tax bill once they’re retired, but that’s not always how it works. Between retirement account withdrawals and Social Security payments, overall income can sometimes rise once someone enters retirement, triggering a higher tax rate.

A few strategies can help you avoid unpleasant tax surprises in your post-work years.

Plan Ahead

Even before you retire, it’s essential to establish a solid estimate for both income and expenses after retirement.

First, inventory all sources of retirement income you anticipate and assess their taxability. Some may be partially taxable, such as Social Security. Others are tax-free, such as withdrawals from Roth IRAs, Roth 401(k) plans, and tax-exempt municipal bond income. Expect to pay standard tax rates on pensions and withdrawals from tax-deferred assets such as traditional IRAs and 401(k) savings plans.

Next, develop a tax-efficient plan for drawing retirement income. For example, you might minimize current federal and state income taxes by tapping nontaxable assets first. Then, draw down assets that generate capital gains, and put off withdrawals from tax-deferred accounts as long as possible.

Also, think about how you’ll address required minimum distributions (RMDs). RMDs from tax-deferred retirement accounts are mandatory once you reach age 72 (70½ for people born before July 1, 1949), although you can defer the initial distribution until April 1 of the year following the year you reach age 72. If you’re approaching age 72 and expect to have substantial RMDs from tax-deferred accounts, you may want to withdraw some of those funds earlier. Waiting until you reach 72 could mean large RMDs later that nudge you into a higher tax bracket.

For example, 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 (and your RMDs) down the road. You can draw funds from nontaxable or capital gains assets if needed.

Another consideration would be to convert funds in a traditional IRA to a Roth, up to the threshold of the next tax bracket. Qualified distributions from Roth IRA accounts are tax-free and do not have any RMDs. However, thanks to the Tax Cuts and Jobs Act, these conversions cannot be reversed, so be sure to consider all angles.

Be Strategic About Social Security Benefits

When is the best time to start collecting Social Security retirement benefits? You can claim them as early as age 62 or wait until later. The longer you wait (up till age 70), the higher your monthly payments will be.

If you don’t need the money right away, delaying when you claim benefits may be a good investment. But every situation is different, so look closely at all the factors that govern your benefit amount before deciding when to claim. For some taxpayers, there’s no advantage in delaying beyond full retirement age.

If your income from other sources exceeds IRS 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.)

Remember, too, that benefits are reduced if you start them before you reach full retirement age and continue to work.

Improve Your Tax Situation by Helping Others

Since bigger RMDs can push you into a higher tax bracket, lowering these annual amounts can be to your advantage. For those who are charitably inclined, making a qualified charitable distribution (QCD) can be an effective way to reduce the amount of RMDs that will be included in your adjusted gross income.

RMDs generally are taxed as ordinary income. However, if you’re age 70½ or older, a QCD allows you to distribute up to $100,000 tax-free directly from an IRA to a qualified charity and to apply that amount toward your RMDs.

Your taxable income is reduced by the amount of your QCD, so you avoid tax on the entire amount — whether or not you itemize deductions. (Some taxpayers itemize in alternate years and use QCDs in the years they don’t 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.

Keep Up with Quarterly Estimated Taxes

Some sources of retirement income may withhold income tax, while others likely do not. To avoid getting hit with a surprise tax bill or penalties for noncompliance, monitor how much income tax is being withheld throughout the year. Compare that amount to your projected total income tax liability based on all income sources, and make quarterly estimated tax payments to cover any expected shortfall.

Keep Close Tabs on Medical Expenses

Under current rules, medical expenses are deductible only if you itemize, and only to the extent that they exceed 7.5% of your adjusted gross income. If you have significant medical expenses, track them carefully. Once you near or exceed this threshold, consider moving elective expenses planned for the future into the current year to maximize your potential deductions.

While these general tips are helpful suggestions, work with a qualified tax professional to determine the best approach for your situation. As you approach retirement age, reach out to your CRI tax advisor to discuss how your tax picture may change in the coming years. We’ll work with you to determine the optimal tax strategy.

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