In many cases, there are ways to avoid owing more taxes - but usually, this requires proactive action beyond tax season. Below we’ll explain four tips you can utilize throughout the year to help minimize your tax obligations in retirement.
Tip #1: Take Your Required Minimum Distributions (RMDs)
An RMD is an amount that must be withdrawn from your retirement account. These required withdrawals begin when you, the retirement plan account owner, reach age 72. The rules apply to employer-sponsored retirement plans, traditional IRA plans, and Roth 401(k) accounts, but they don’t apply to Roth IRAs when the account owner is still alive.
Some IRA custodians and retirement plan administrators might find out what your RMD is for you, but the responsibility ultimately falls on you. To find out what your RMD is, the IRS provides life expectancy tables to utilize according to your circumstances. If you do not withdraw the RMD (or the correct amount), the amount not withdrawn will be taxed at 50 percent, which is why it’s critical to take your RMDs and withdraw the correct amount.¹
If you are charitably inclined and don't need the income from your RMD, you may want to consider a Qualified Charitable Distribution (QCD). A QCD allows you to direct all or a portion of your RMD (up to $100,000 per individual per year) to a qualified 501(c)(3) organization (a charitable organization eligible to receive tax-deductible contributions) and exclude the distribution from your taxable income.² Be sure to consult your tax advisor if you think this strategy would be beneficial to you.
Tip #2: Manage Your Income Combinations
As a retiree, a portion of your income will likely come from Social Security. However, not all of your benefits are taxable, and there are ways to minimize or, at times, eliminate taxes on your Social Security benefits.
If half of your Social Security benefits in addition to your other income is higher than the base amount for your status, your benefits will be taxable. By strategically managing all of your income sources (such as pension payments, dividends, or part-time jobs), it’s possible to lower the portion of benefits that will be taxed. Rules regarding Social Security income taxes also vary from state to state, so always check with your state regulations to determine the best solution for you.³
You will also want to understand the impact that distributions from various types of retirement (Roth vs. Traditional IRA) and investment accounts (taxable dividends/interest vs. tax-free dividends/interest) will have on your Social Security benefits.
Tip #3: Figure Out if You Need to Pay Quarterly Taxes (If Not, You May Decide to do it Anyway)
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 estimated tax.
In some cases, you might decide to pay quarterly taxes, even if you are not required to, in an effort to avoid the inconvenience of paying a large sum all at once. If you miss a payment or underpay, you may be charged a penalty.⁴
If you are taking distributions from an IRA or 401(k), be sure to determine if you should be withholding taxes from these distributions as well. The withholding percentage from these accounts may also allow you to account for taxes to be paid on other sources of income.
Tip #4: If You’re Moving to a New State, Get to Know Its Tax Laws
If you’re relocating to a new state during retirement, consider the impact of the move on your financial situation, as tax laws vary according to the state. For example, some states, like Florida and New Hampshire, don’t tax on income or only tax on dividends and interest.⁵ On the other hand, they may have higher property taxes. For example, New Hampshire’s property taxes are high compared to the rest of the country.⁶ 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.
In many cases, an individual or couple is working with a fixed amount of wealth to last throughout retirement, which is why taking the right financial steps is essential. By working with an advisor and keeping these four tips in mind during the year, you can make sure you’re not paying more than you need to. When it comes time to finalize gifting to your children or grandchildren, you can further reduce taxes by incorporating other strategies, like charitable giving, into the equation.⁷