Individuals who have retired may expect that their taxes will become simpler than they were prior to retirement, with little or no need for tax planning. While in some cases this may be true, often there are new and more complex issues that require careful consideration and consultation with advisors. In addition to minimizing income tax to boost retirement cash flow, retirees with large estates should also explore estate tax strategies to increase the amount that they can pass on to heirs. This article discusses several aspects of tax planning that individuals in retirement, or approaching it, should be aware of.
Required Minimum Distributions
Retirees with employer-sponsored retirement plans and/or traditional individual retirement accounts (IRAs) must begin taking required minimum distributions (RMDs) from those accounts once they reach the age of 72. The calculation of the RMD depends on the individual’s age, meaning that a greater percentage of the retirement account must be distributed in each successive year. These distributions are subject to income tax unless the contributions to the account were made with after-tax funds, such as in a Roth IRA. The RMD rule does not apply to Roth IRAs; as a result, the balance in a Roth IRA is not required to be distributed until it is passed down to beneficiaries after death.
Planning Tip: Depending on an individual’s other sources of income in retirement, it may be beneficial from a tax perspective to begin taking distributions earlier than the required age of 72 (individuals can generally begin taking distributions without incurring a penalty at age 59 ½). Spreading the income out over a greater number of years may result in lower tax rates by avoiding being pushed into a higher tax bracket.
Managing Taxable Investments
In addition to retirement accounts, retirees may also own stocks, bonds and other securities in taxable investment accounts. When deciding which assets to hold in these accounts, the tax implications of the various alternatives should be considered. Some investments are more tax-efficient than others, due to variations in investment turnover and the types of dividends and capital gains generated. In general, passively managed funds with lower investment turnover are more tax-efficient than actively managed funds with high investment turnover. Similarly, stocks and mutual funds that pay qualified dividends and generate long-term capital gains are more tax-efficient than those that pay nonqualified dividends and generate short-term capital gains. Many retirees also allocate a portion of their portfolio to municipal bonds, which pay interest that is exempt from federal income tax (and in some cases state income tax as well).
Planning Tip: Liquidating assets from taxable accounts to provide retirement income may result in a lower tax bill than taking distributions from tax-deferred retirement accounts. The current maximum federal income tax rate on long-term capital gains is 20%, while distributions from tax-deferred retirement accounts are taxed at ordinary income tax rates of up to 37%. However, this technique is only viable if there are assets in the taxable account that have been held for at least a year and a day, thus qualifying for long-term capital gain treatment. Capital gains generated from assets held for less than this required period will be treated as short-term and subject to ordinary income tax rates.
Social Security Benefits
Individuals who have paid into Social Security are eligible to begin receiving benefits as early as age 62, but can delay the beginning date until age 70. Deferring the receipt of Social Security benefits results in additional credits that will increase the amount of the monthly payments. Only a certain percentage of benefits is taxable, ranging from 0% to 85%, based on the recipient’s income (including tax-free interest on municipal bonds). For a married couple filing a joint return, the maximum percentage of 85% of benefits received will be taxable if their combined income is over $44,000.
Planning Tip: Individuals with substantial retirement assets including IRAs, 401(k)s, and annuities should consider deferring the receipt of Social Security benefits until the latest possible year. Any income needed before the age of 70 can be funded by distributions from the other retirement assets. This strategy will not only increase the Social Security benefits available, but also delay the taxation of those benefits.
Medical expenses can be a significant cost for many retirees, and in some cases can be used as a deduction to offset taxable income. Under current law, medical expenses can be deducted to the extent that they exceed 7.5% of adjusted gross income (AGI). Individuals who itemize deductions should track their expenses carefully and keep copies of receipts for medical products and services. The list of deductible medical expenses is extensive and includes amounts paid for the following:
- Diagnostic services, such as an annual physical exam or x-ray
- Prescription medicine and drugs
- Surgery (not including cosmetic procedures)
- In-patient hospital care
- Dental care
- Nursing services
- Contacts, eyeglasses, and hearing aids
- Transportation primarily related to medical care
- Qualified long-term care services and premiums paid for qualified long-term care insurance
- Medical insurance premiums, including premiums paid for supplementary insurance under Medicare Part B
Planning Tip: An effective way to increase the available deduction for medical expenses is to bunch non-urgent, controllable expenses, such as eyeglasses and dental care, into alternating years. This technique can result in a larger medical expense deduction due to the 7.5%-of-AGI threshold. For example, assume a taxpayer with annual AGI of $100,000 has $8,000 of medical expenses in each of Year 1 and Year 2, $2,000 of which are for non-urgent, controllable expenses. By accelerating Year 2’s controllable expenses into Year 1, the taxpayer’s total medical expenses in Year 1 are $10,000, resulting in a tax deduction of $2,500. This deduction is greater than the combined deduction of $1,000 over Year 1 and Year 2 that would be available if an equal amount was paid for medical expenses in each year.
The estate tax, which is a tax on the transfer of property at death, applies to estate values exceeding $12,060,000 as of 2022 ($24,120,000 for a married couple). For retirees with potentially large taxable estates, it is important that they draft or update their estate plans to minimize the amount of estate tax paid and maximize the amount of assets available to beneficiaries. Care should also be taken to ensure that beneficiaries are designated for all retirement accounts. If there is no named beneficiary, the estate may become the default beneficiary and be required to take distributions on a more accelerated schedule than if a spouse or other family member was the named beneficiary. As a result, the tax liability on post-death distributions may be increased and funds within the accounts will have less time to grow in a tax-deferred environment.
Planning Tip: For many wealthy individuals, the use of lifetime gifts is an effective way to reduce the size of the taxable estate. In 2022, a donor can give up to $16,000 to another individual without incurring gift tax ($32,000 for a married couple). This exclusion amount is available to the donor each year and applies to each separate recipient. Another option available to donors is to pay for another individual’s qualified medical or educational expenses directly to the medical provider or educational institution. These transfers are not treated as gifts and thus no gift tax will be incurred, regardless of the amount.
Planning for taxes during retirement is essential to be able to achieve financial goals and provide for future generations. The issues involved are often complex, and decisions require consideration of non-tax factors as well. If you have questions about retirement tax planning, please contact your Bennett Thrasher tax advisor by calling 770.396.2200.