People working toward a milestone of financial freedom (however they choose to define it) generally focus on savings and investing for the future. Taxes on income and investments are moderately less complicated during the working years, so they don’t always drive decision making. But when people retire and begin to utilize their savings, Social Security and other income sources to build a retirement paycheck, the tax impact can be a surprise.
As we become more familiar with the effect of the new income tax bill upon filing our 2018 returns, several areas are important to be tax-smart about, especially for retirees. For many retirees, the most substantial tax-related element of managing money is their IRA or 401k. Social Security, pensions or annuities, and Medicare premiums add to tax-related decision points relevant to managing money in retirement.
Tax-deferred retirement savings accounts have now existed for a full working lifetime. IRAs debuted in 1974 and 401k accounts began in 1978. Of the 10,000 Baby Boomers retiring every day in the U.S., most have utilized these accounts to some extent to hold pre-tax dollars. But upon withdrawal, retirees are reminded that the government has been a partner in these accounts and will, over time, capture its share of ownership.
Disciplined savers who accumulate sizable pre-tax retirement savings, but not much in after-tax Roth accounts or non-retirement brokerage accounts, can wind up with relatively tax-inefficient income. Especially after age 70 1/2 when required minimum distributions must commence from pre-tax 401ks and IRAs, it’s common for retirees to see their income still in higher tax brackets than they assumed. For many people, it’s a myth that retirement will bring lower taxation than the working years.
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When IRA/401k income combines with Social Security, it usually causes the amount of Social Security income subject to taxation to rise. If the total of one-half of your Social Security benefits plus your other taxable income is more than $34,000 ($44,000 if you are married filing jointly), you’ll owe ordinary income tax on 85 percent of the Social Security income instead of just 50 percent. Social Security is partially a return of taxes you paid throughout your working life, but yes, those dollars are taxed again as income to you.
The flip side of your Social Security income is the cost of Medicare premiums, which for most people are netted out of Social Security payments. High-income earners pay more for Medicare, essentially an increased tax. If you don’t manage your income around the Medicare premium thresholds, you could see your premiums double from one year to the next. Higher Medicare premiums catch people by surprise usually in the aftermath of a large pre-tax retirement account withdrawal. If you take a significant sum out of the 401k or IRA to buy a vehicle, fund a substantial vacation or buy a cabin, for instance, the boost to your taxable income could cause Medicare costs to rise. Review the Medicare Premiums: Rules for Higher-Income Beneficiaries pamphlet on the Social Security website to understand the income thresholds that cause premiums to rise when income exceeds $85,000 for singles or $170,000 for married tax filers.
For some people, rather than managing income, it’s managing deductible expenses that provides the greatest opportunity for tax-related creativity. Particularly, medical expenses can provide an opportunity for tax-friendly money management. If you or your spouse have large deductible medical expenses that reduce taxable income, there are strategies that you should consider applying. You could make intentionally larger IRA/401k withdrawals to fill up a low tax bracket. Move the extra withdrawal proceeds to a brokerage account if you can continue investing for longer-term gains. In this type of account, at your death, there could be a step up in cost basis allowing a tax-free transfer to your heirs. If money remained in your IRA, it would be taxed at your heir’s tax rate upon withdrawal.
Coordinating taxation of various types of accounts can provide more options to stretch your money for longer and make your money work harder for you. And if you expect that your money is likely to outlive you and be a welcome gift to your heirs, it may be beneficial to consider strategies for Roth IRA conversion. The conversion would move forward taxation of current pre-tax IRA money. However, done strategically during low-tax-rate years, could recharacterize money that would otherwise be more heavily taxed upon receipt by your heirs.
You can spend money only in the after-tax world. Making a few key decisions can reduce your taxes, increase your after-tax investment return, and help you increase your financial security without taking any more market risk.