It's easy to begin daydreaming about retirement and the fun aspects of life after work; it's even easier to overlook one significant expense; taxes. According to Nationwide's 2021 Retirement Income Survey, 41% of retirees surveyed wished they were better prepared for taxes leading up to retirement.1
Tax laws change frequently, and the various sources of your retirement income can be taxed differently than you have grown accustomed to. With a little bit of strategic, proactive tax planning, you could save thousands of dollars throughout retirement. This article covers three things you need to know about taxes as you plan to transition into the next phase of your life.
Tax Rates Aren't Always Lower
With lower or no earned income during retirement and the assumption that spending will decrease, many retirees believe that taxes will follow suit and decline. However, this isn't always the case. Several other factors affect your annual tax liability.
As the retirement door opens, the door to some of your typical federal tax deductions closes. Payroll deductions for 401(k) contributions and your IRA contributions will stop once you no longer have earned income. Contributions to the triple-tax-free Health Savings Account are forbidden once you are enrolled in Medicare. Even accomplishing paying off your mortgage means losing the ability to deduct the mortgage interest from your taxable income. Sometimes it can be challenging for those who took advantage of these deductions over the years to find other deductions to replace their impact.
For now, the good news for retirees with minimal itemized deductions came during the Trump administration, where a significant overhaul to the tax code substantially increased the standard deduction. The standard deduction in 2021 for those who are married, and file jointly is $25,100. If both spouses are over 65, that amount increases to $27,800. Deciding on taking the standard deduction simply comes down to running the numbers for your allowable itemized deductions and determining which gives you the most significant deduction.
Depending on your forms of income and your eligible deductions, your taxes may not be lower. In fact, you could easily end up with a similar tax bill to when you were employed.
Required Minimum Distributions (RMDs)
The tax deferral in retirement accounts is only a temporary gift. Once you reach 72, the government is no longer as generous with gift-giving, and they want to start collecting, in the form of more tax revenue. As such, they start mandating required minimum distributions (RMDs) from your retirement accounts, such as 401(k)s and Traditional IRAs. For those who were diligent with traditional retirement contributions, you could find your RMD amounts coupled you’re your other income sources is greater than your salary when you were employed.
RMD income from traditional retirement accounts is taxed as ordinary income, just like if you were still working and collecting earned income. Qualified Charitable Deductions (QCDs) are the only way to waive the taxation of your RMD. To benefit, you must be over 70. Your charitable donation can be any amount up to $100,000 and must be made payable directly to a charitable organization.
Unlike traditional investment accounts, Roth IRAs have the unique advantage of not requiring minimum distributions. Roth IRAs can play a beneficial role in income planning as they also provide tax-free income upon reaching age 59 1/2, as long as the account has been opened for five years or longer).
Each account type and planning strategy has its advantages and roles in retirement income planning. Finding a balance between investing in different kinds of accounts is essential if you want to minimize your overall tax liability while saving for retirement. From retirement leading up to age 72, strategically planning your income could save money over the long haul. It may make sense to take IRA withdraws even if funds are not needed for annual cash flow, or if other cheaper sources are available.
Taxes on Social Security and the Medicare Surtax
While the most common retirement income comes from social security, not all social security benefits are taxed equally. As your provisional income level increases, so does the amount of taxes on your benefits.
While the term provisional income sounds complex, the calculation is relatively simple. Your provisional income is comprised of 50% of your social security benefit, gross income, and any tax-free interest received.
In 2021, no matter your income level, 15% of social security benefits received remain tax-free, meaning up to 85% of your social security benefit could be subject to federal income tax. Lower-income levels could see up to 50% of their social security benefit taxes, and the lowest income levels would not be subject to any taxation on their benefit.
Higher-income retirees should not only consider taxation on social security; they may also be subject to Medicare surtax. Over certain income levels, a surcharge is added to your Medicare Part B premium.
Income planning and investment strategies can have a tremendous difference in monthly Medicare expenses. Having tax-free sources of income available during retirement can help avoid the Medicare income thresholds. Since taxable interest and realized capital gains are included in the income level, incorporating tax-advantaged strategies can help investors who are nearing those thresholds. Consider techniques such as tax-loss harvesting to realize losses and offset gains, ideally dropping your income below the surcharge levels.
Currently, tax rates are hovering near historical lows; government spending is poised to increase, so tax increases are also likely. Strategic tax planning is essential if you want to avoid overpaying and minimize your overall tax liability. By knowing how different types of income are taxed and what your available options are, you can begin developing a strategy that helps give Uncle Sam the cold shoulder. To learn more, join our upcoming webinar on October 21st.
1. The Harris Poll. 2021 Nationwide Retirement Institute® Tax-Efficient Retirement Income Survey. March 25, 2021. Nationwide Financial.
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