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7 Yearlong Tax Tips for Retirees

When you are retired, your money hast to last for the rest of your life, so making the right financial moves is critical. Whether you’re working with an advisor or managing your finances yourself, one central goal during retirement is protecting your wealth from unnecessary taxes. 

Most of us only think about taxes once a year—when we have to file our returns.  (This year the magic date is July 15—next Wednesday.)  However, minimizing your taxes often requires tax planning and proactive action beyond tax season. Below are six tips you can utilize throughout the year to help reduce your taxes during your retirement years.

Tip #1: Emphasize Preferential Investment Income

When it comes to taxes, both your level of income and the type of income matter.  The (relatively) good news is that under the current tax code, long-term capital gains and “qualified dividends” (the kind paid by most corporations) qualify for preferential tax treatment at lower rates.  For married filing jointly (MFJ) taxpayers, the first $80,000 (or for single filers, the first $40,000) in preferential investment income is tax-free. That’s right. It’s ZERO.

For preferential incomes above those levels, the tax rate is only 15% up to very high levels:  $469,049 for MFJs and $441,449 for single filers.   And above that, the tax rate is only 20%.1

So, from a tax perspective, the best kind of income is either long-term capital gain or qualified dividend income.

Tip #2: Carefully Manage Ordinary Income 

The highest federal income tax rates apply to “ordinary income,” such as: 

  • Distributions from tax-deferred retirement plans (such as IRAs)
  • Wages, tips, and salary
  • Short-term capital gains
  • Interest income
  • Non-qualified dividend income (from REITs and MLPs)

The current federal ordinary income tax brackets for married taxpayers filing jointly (MFJ) jumps from 12% to 22% (an 83% increase) at incomes over $80,250. However, if you add the standard deduction of $12,400 for MFJ taxpayers to that figure, the jump doesn’t occur until an income of $92,650. (Commensurate figures for single filers are half of those for MFJ filers.)2 Therefore, steps that will help keep ordinary income below the 22% bracket will help keep taxes low. (However, it is important to note that only the amount that goes over the line is taxed at the higher rate, not all income.)

Of course, having income is a good thing.  It’s the taxation of income that we seek to minimize. Some types of income can be controlled more easily than others, such as the realization of capital gains.  One strong recommendation I have is to avoid the realization of short-term capital gains (that can’t be netted against offsetting capital losses). Another is to emphasize qualified dividend income (from stocks) over non-qualified dividend income (from REITs and MLPs) or interest income (from bonds).

Tip #3: Do Some Roth Conversions 

Many retirees have substantial assets in their traditional 401k and IRA plans.  The required minimum distributions (RMDs) from these plans start at age 72.  Often, these RMDs will generate considerable ordinary income and push them into higher tax brackets.  One strategy for lowering the taxes on tax-deferred retirement plans is to convert some of the assets in traditional plans into Roth plans, distributions from which do not generate any taxable income.  Ever.  However, the conversion from traditional to Roth involves paying taxes on the assets that are distributed at the time of conversion.  So, if possible, you will want to take these voluntary distributions when your tax rate is relatively lower.  Many retirees have “gap years” before they start taking Social Security and before RMDs start at age 72.  During the gap years, income is often lower than it will be later in retirement, and therefore you may be in a lower tax bracket than you will be in later on.  These gap years are an opportune time for Roth conversions.3  

Tip #4: Delay Social Security 

I generally recommend waiting until age 70 to begin taking Social Security benefits, although careful consideration of individual circumstances is always warranted. IRA withdrawals can also be taken as a “gap” funding source to facilitate delaying Social Security benefits until age 70 as long as you are at least age 59 ½.  Spending down traditional IRA assets during the gap years also reduces the size of RMDs later.  The growth in Social Security benefits of about 8% for each year of delay usually makes this an optimal strategy.4  

Tip #5: Give Some of Your RMD to Charity

“Qualified Charitable Distributions” (QCDs) allow IRA owners who are age 70 ½ or older to directly transfer up to $100,000 annually from an IRA to charity, tax-free. If you are married, you and your spouse may both transfer $100,000 for a total of $200,000. After the Tax Cuts and Jobs Act of 2017, QCDs became more valuable than ever. Many taxpayers now take the standard deduction, eliminating the tax deduction for charitable gifts. QCDs add to the standard deduction by allowing the donations made from the IRA to be excluded from income. With a QCD, you get a tax break for your charitable contribution even if you are using the standard deduction.5  

Tip #6: Avoid IRS Penalties 

As part of the Coronavirus Aid, Relief, and Economic Security Act, or CARES Act, passed on March 27th, 2020, RMDs are not required in 2020. However, in future years, if you do not withdraw the correct RMD, the amount not withdrawn will be taxed at 50 percent.  That’s why it is critical to stay on top of your RMDs.7  Some IRA custodians and retirement plan administrators might tell you the correct amount of RMDs for accounts you have with them. However, you may have multiple tax-deferred retirement accounts and not all firms provide this service.  Ultimately, final responsibility falls on you. To find out what your RMD withdrawal rate is, the IRS provides life expectancy tables to utilize according to your circumstances.

Penalties may also be assessed if you under-withhold taxes during the year. If you don’t have taxes withheld automatically, you may need to pay estimated tax payments. Individuals who are expected to owe $1,000 or more—or those whose withholding and refundable credits are 1) less than 90 percent of the tax owed or 2) at least 100 percent of the tax on the previous year’s return—must pay quarterly estimated taxes. If you miss a payment or underpay, you may be charged a penalty.8

Tip #7: Move to a State with Lower Taxes

In addition to nicer weather or a more serene lifestyle, you might decide to move to a new state in an effort to save on taxes. Income, property, sales, and inheritance taxes vary widely from state to state.9 Some states (including Pennsylvania) do not tax retirement income.10 Moving might be worth considering!

    1. https://www.thebalance.com/dividends-on-tax-returns-3193086
    2. https://taxfoundation.org/2020-tax-brackets/
    3. https://sapientinv.com/investment-articles/is-your-ira-a-ticking-tax-bomb
    4. https://mailchi.mp/4661610c8f97/social-security-analyzer
    5. https://www.irahelp.com/slottreport/qcds-%E2%80%93-still-available-2020-and-still-good-strategy
    6. https://www.congress.gov/bill/116th-congress/house-bill/748/text
    7. https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-required-minimum-distributions#1
    8. https://www.irs.gov/publications/p505#en_US_2019_publink1000194564
    9. https://smartasset.com/retirement/retirement-taxes
    10. https://rodgers-associates.com/blog/pros-cons-retiring-in-pennsylvania/

This content is developed from sources believed to be providing accurate information, and provided by Sapient Investments. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered tax advice or a solicitation for the purchase or sale of any security.