The truth about taxes in retirement

WASHINGTON — Taxes are a fact of life, even in retirement. How much you will be required to pay could have an effect on your lifestyle during this phase of your life. Whether you’re just beginning this new chapter or are already in retirement, it’s important to understand the potential tax impacts as you move through the various stages.

It’s important to remember that, beginning at age 59.5, you can take distributions from your retirement accounts without fear of the 10 percent early withdrawal penalty. And withdrawals from a retirement plan, including 401(k), 403(b), traditional IRA or SEP, are taxed as ordinary income. At age 70.5, required minimum distributions (RMDs) are mandatory.

Whether you’re still in the accumulation phase or beginning to enter semiretirement, ask yourself the following questions so that you’re not surprised at tax time.

If you’re semiretired 

An increasing number of aging Americans are choosing to try out retirement by continuing to work part-time before they transition to full retirement. If you’re considering a reduction in your hours, here are three questions to consider:

How will I pay for health care?

If you plan to reduce your hours, make sure you understand how this will impact the cost of health insurance, especially if your employer covers some or all of the premiums. One way to save for semiretirement health care costs is to maximize Health Savings Account (HSA) contributions. HSAs are only available if you have a high-deductible health plan. They allow contributions up to $6,750 for a family plan, plus a catch-up contribution of $1,000 if you are at least age 55.

HSAs are great for several reasons. First, contributions are pretax. Second, as long as the money is used on qualifying medical expenses, all distributions are not taxable and the growth is tax-free. The money can be used whenever needed and can accumulate for as many years as you wish. You don’t need “earned income” to contribute to an HSA. Once enrolled in Medicare, however, you are no longer allowed to contribute to an HSA, so get it funded before you turn age 65. Read “7 Things You Need To Know About Health Savings Accounts” for more ideas.

Also, keep in mind that starting in 2019, the deduction for medical expenses will need to exceed 10 percent of your adjusted gross income.

Can I contribute to a retirement account?

We recommend you defer as much of your earnings toward retirement as you can afford, even if you’re in semiretirement. If possible, defer income to a 401(k) plan, especially if the employer matches contributions. Some employers allow Roth 401(k) contributions, so make sure to review the options. If you’re over age 50, you can defer up to $24,500 to a 401(k). Also consider post-tax retirement contributions. You are allowed to defer a total of $55,000, including both your employee and employer’s contributions.  So, if you maximize your pretax 401(k) contribution at $24,500 and your employer matched another $5,500, you could defer another $25,000 with post-tax dollars.

Should I roll over my retirement accounts to an IRA?

Once you fully retire, you may choose (or be forced to) move assets out of your company retirement plan. There are many reasons to consider this option including greater investment choice, lower expenses or consolidation of accounts.  What many people don’t know is that some employers allow an “in-service withdrawal” before retirement. In the example above, if you’ve contributed to both a pretax and post-tax account, you can move the money over to two IRA accounts. The pretax dollars go into a traditional IRA and grow tax-deferred. The post-tax dollars go into a Roth IRA and grow tax-free!

What if I own a business?

If you own a business during your retirement years, one tax law change that could be very favorable is the new 199A Qualified Business Deduction. A 20 percent deduction is allowed on the combined qualified business income for individuals and trusts. To understand more about this complex deduction, read “How Business Owners Could Reap Big Tax Savings.”

If you’re retired and deferring Social Security 

Given the additional benefit you receive by deferring Social Security to age 70, many retirees are living with no Social Security in the first few years of their retirement. If this is the case for you, the following two questions may arise:

How should I withdraw money to cover my living expenses? 

The first step is to determine how much you need to cover your cost of living. The harder question is where to take that money from. If you don’t have or need much income, you may want to consider tapping into your taxable IRA first. Although proceeds may be taxable, you may be able to stay in a low or perhaps zero tax bracket. If you are already in a high tax bracket, it may be better to tap any Roth IRA assets first.

When should I begin taking Social Security?

The answer to this question depends on many factors, including your health, how much money you need to live on, your marital status and partner’s benefits, and current market rates of return.  One tax impact many miss is that deferring Social Security until age 70 while also having a sizable IRA with RMDs can push you into a higher tax bracket.  If this is your situation, it may make sense to accelerate income before enrolling in Social Security in order to reduce taxable income after age 70.5.

Another strategy for taking advantage of low income years before Social Security and RMDs is to use low-bracket years to convert IRA assets to a Roth.  Doing so can have long-term positive income tax and estate planning benefits for you and your family.

There is one major change to IRA conversions due to the new tax law: Filers can no longer re-characterize Roth IRA conversions back to a traditional IRA. This would typically be done if the stock market took a downturn after conversion.

If you’re retired and receiving Social Security

Once you begin receiving Social Security, consider that income as you determine the most tax efficient way to supplement with withdrawals from other assets. It’s helpful to understand the potential additional income tax you may owe if you tap into taxable assets versus using retirement funds. If you’re not careful and add too much taxable income, you could unwittingly trigger taxation of your Social Security benefits. Simplistically, 85 percent of your social security benefits are taxed once joint income exceeds $77,000.

If you’re fortunate enough to have more income than you need to cover your living costs, you may ask a common question: “What are my options if I don’t need my RMD?”

Of course, one option for RMD money is to simply deposit it into your taxable account and save it for future spending needs. If you are charitably inclined, you can direct some or all of your RMD to be paid directly to a charity. That reduces your taxable income and effectively makes the charitable contribution paid for with pretax dollars.

Gifting your RMD is particularly effective starting this year because, if you defer your RMD (s) to charity, you pay tax on that much less income and still get the newly increased $24,000 standard deduction! If you want to employ this tax strategy, we recommend you wait until December to take your RMD and crunch some numbers to get a sense for what the tax savings will look like whether you itemize versus taking the standard deduction.

Communication with your advisers is key through all stages of life. If you act early and ask tax-related questions along the way, you may be able to implement strategies to reduce your tax costs in retirement. That can improve your financial situation and your chances of fulfilling your retirement goals.

Dawn Doebler, CPA, CFP®, CDFA® is a senior wealth adviser at The Colony Group. She is also a co-founder of Her Wealth®. Sean Kelly, CPA, is a Senior Tax Manager at The Colony Group.


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