When you start putting money away for retirement, you might be thinking of the tax benefits or consequences you'll incur. But you should also have an understanding of how your taxes in retirement will affect your savings and your future income. Here are seven tips to help you restructure your payment strategies to optimize your tax results in the areas of Social Security, 401(k)s, and IRAs.
1. Pay attention to Social Security and other income amounts
If you worked for an employer or had net profits from self-employment before retirement, you'll receive Social Security benefits in retirement. If during retirement you only have income from Social Security benefits, then you will not include those benefits in your gross income. In this case, your gross income will equal zero, and you won't have to file a federal income tax return.
If you have income that is not tax-exempt, you may have to pay income taxes in retirement. For the tax year 2020, if you are filing jointly with a spouse who is also 65 or older, you will file a return and pay taxes if your income exceeds $27,400 ($26,100 if your spouse isn't 65). It's important to note that these amounts are different from previous tax years, and these amounts will probably increase slightly each year.
If the sum of half your Social Security benefits plus any other income exceeds $25,000 for those filing single or $32,000 for those filing jointly, then you will have to include some of your benefits as taxable income. If you are married but file a separate tax return from your spouse and live with your spouse at any time during the year, then 85% of your Social Security benefits will be taxable income.
If you still have earned income from a part-time job or other sources, you may meet the threshold that requires you to pay taxes on your Social Security benefits during retirement.
- For single filers, if your combined income (your adjusted gross income, plus nontaxable interest, plus half of your Social Security benefits) is between $25,000 and $34,000 (or $32,000 and $44,000 for married people filing jointly), you may have to pay taxes on 50% of your Social Security benefits.
- If your combined income is more than $34,000 (or $44,000 for married people filing jointly), you may have to pay taxes on up to 85% of your benefits. The IRS will not tax more than 85% of your Social Security benefits.
If you will have taxable income, be sure to see if you meet age and income requirements to file for the Credit for the Elderly or the Disabled. To claim this credit, complete and attach Schedule R to your Form 1040. This credit may allow you to reduce your income tax.
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2. Limit income from pretax retirement plans
If you have funds in a pretax plan, such as a 401(k) or funds in an employer-funded pension, withdrawals you make from these plans after you retire are generally subject to income tax. You can usually have the plan administrator deduct taxes from your distributions — but, depending on your tax bracket, it may not be enough to cover your bill.
Ultimately, your tax rate is based on all your taxable income during the year. If you have multiple sources of retirement income, you'll save on your taxes in retirement if you limit distributions from pretax plans to only the amounts you need or are required to withdraw.
3. Understand your traditional IRA tax treatment
Traditional IRA distributions may be fully or partially taxable or not taxable at all, depending on how you treated your contributions before you retired. If you took a tax deduction for contributions you made to the plan in prior tax years, your distributions are likely taxable when you withdraw them, up to the amount you previously deducted.
Traditional IRA contributions are usually made with after-tax dollars, so if you did not take a deduction for some or all of your contributions, the withdrawals you make from these non-deducted contributions are not taxable. That is because you already paid taxes on the money you put in the account, and you didn't receive a tax benefit for those deposits. Similar to 401(k) plans, if you deducted traditional IRA contributions from your income in earlier tax years, you may want to limit your retirement withdrawals to reduce your potential tax burden.
4. Maximize your tax benefits with Roth IRA distributions
Contributions you make to a Roth IRA account are made with after-tax dollars, and you don't have the option of deducting these contributions from your income. This makes withdrawals from a Roth IRA during retirement totally tax-free.
According to IRS enrolled agent Brittany Brown, "Roth IRA withdrawals give the best of both worlds to retirees. You get regular retirement income and no income tax. This is important for seniors because there just aren't a lot of tax credits or deductions available for people who have unearned income and no longer have dependents to claim."
You could increase your retirement income options and decrease your future tax consequences by drawing from a Roth IRA or contributing to a Roth IRA for future use. Also, if you're still working at retirement age but you're in a higher tax bracket now than you will be later, limit taking withdrawals from a Roth IRA until you're at that lower tax bracket.
5. Convert pretax plans to a Roth IRA
If you want to move your retirement funds from one type of plan to another, the IRS allows you to do this. For example, you can convert funds from your 401(k) account or traditional IRA account to a Roth account. Converting your funds will reduce future tax liabilities, but in the year of the conversion, you'll pay taxes on any pre-tax funds you convert.
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6. Prepare for required minimum distributions (not required for 2020)
Most retirement plans (except for Roth IRA plans) are subject to required minimum distributions (RMD). Beginning with the year you turn age 72, you must begin making annual required minimum distributions. Your first withdrawal must be made by April 1st of the following year. Withdrawals for years after the year that you turn 72 must be made by the end of that calendar year.
If you fail to make the necessary withdrawals, the IRS can assess a penalty against you. The penalty is 50% of the amount that you should have taken out. If you are still working, you can delay withdrawals from 401(k) plans but not from IRAs. To avoid this penalty, use the required minimum distributions calculator on the IRS website to determine when you should start taking required minimum distributions and the amount you must withdraw.
Due to COVID-19, the required minimum distributions requirement for the tax year 2020 was suspended, but all other tax years should expect to have this requirement.
For retirees that are 59½ or older, plan ahead by taking out just enough money from your 401(k) or traditional IRA to stay in your current tax bracket while also lowering the amount that will be subject to RMDs.
7. Diversify your retirement income
To maximize retirement income, Brown says it's important to diversify your income sources when possible. "If you have money coming from different retirement sources, try to take a little from both your taxable and nontaxable sources. You must meet your RMD requirements, but when you mix it up a little, you'll keep your taxable income amount low, and this keeps your overall tax bill low."
Tax breaks for retirees
- When filing single, the standard deduction for those 65 and older is $1,650 higher than for those under 65. When filing jointly, the standard deduction is $1,300 higher if one spouse is 65 or older and $2,600 higher if both spouses are at least 65.
- Workers who are 50 or older can contribute an extra $1,000 to an IRA. This extra contribution can lower your current tax bill while also helping to fund your retirement.
- Workers who are 50 or older can also make catch-up contributions to eligible 401(k) plans. This is another way to lower your current tax bill while planning for the future.
- Those who are self-employed in retirement can deduct Medicare Part B and Part D premiums, as well as the cost of supplemental Medicare or the Medicare Advantage plan whether or not you itemize. You can claim this deduction as long as you don't have access to a health plan either through your employer or your spouse's employer.
- If you are over age 70½, you can make a qualified charitable distribution of up to $100,000 per year directly from your traditional IRA without paying taxes in retirement on that money. Some people make this contribution as a way to meet their required minimum distributions. If you choose to do this, you can't also claim the deduction on your Form 1040, Schedule A.
- For those who don't itemize in 2020 and 2021, you can still take a deduction of up to $300 for cash donations to a charity.
- The Credit for the Elderly or Disabled is a tax credit available to those 65 and older, and it benefits those with low incomes. If filing jointly, both you and your spouse must meet the age requirement.
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