Just because you're retired doesn't mean your worst tax surprises are behind you.
With tax season officially upon us, it's as good a time as any for those who've just entered retirement or who plan to do so this year to get acquainted with some of the pitfalls that lie ahead. Mike Lynch, vice president of strategic markets for Hartford Funds, notes that there are a few elements of the tax code that can be overlooked during retirement planning.
“Oftentimes clients don’t realize that they may have to pay taxes on the Social Security they collect, and that the tax percentage can be fairly substantial,” Lynch says. ”That amount might be more than they bargained for, literally and figuratively.”
If your combined income -- your adjusted gross income not including Social Security, your non-taxable interest and 50% of your Social Security benefit -- exceeds a certain threshold, you may have to pay taxes on your Social Security benefits. Also, as your income rises through withdrawals from retirement funds or other taxable income, more of your Social Security benefit may be taxable. Depending on combined income, up to 85% of Social Security benefits may be taxable. Currently, the threshold for paying taxes on Social Security benefits is $25,000 for the single filers or $32,000 married filing jointly.
“These figures seem fairly low, and they may come as a surprise to many who have worked hard and for many years in an effort to grow their wealth,” Lynch says. “Because the combined income threshold generally applicable to married couples is lower than what some retirees may realize, they may be caught off guard and find that they have not anticipated the tax impacts in retirement or how they will affect their desired retirement lifestyle.”
Anthony D. Criscuolo, a senior financial planner with Palisades Hudson Financial Group in Fort Lauderdale, Fla., calls that the Social Security “tax torpedo,” but notes that there are ways for tax-paying retirees to avoid it. If you're retired and collecting Social Security before age 65 or 67, you'll often need to supplement those with taxable withdrawals from an IRA or other retirement account. Just be careful: When income in early retirement exceeds relatively modest levels, your it could increase your marginal tax rate.
“If you take your Social Security benefit relatively early, allow for the ripple effect that taxation of your benefits could have on your overall tax rate,” he says. “Understanding the Social Security tax is the first step in reducing it.”
Being careful with your retirement fund withdrawals can help eliminate some of the nastier surprises. Crisculolo notes retirees should withdraw from taxable accounts first, since stocks and mutual funds that have appreciated longer than a year are subject to a typically low long-term capital gains tax. Once the taxable accounts are tapped, tax-deferred accounts including traditional IRAs, 401(k) plans, SEP-IRA that are taxed at your regular income tax rate should come next. If you can get to them early, that's great, considering that you have to take a required minimum distribution from them each year once you reach age 70.5. If you don't, you'll have to pay an onerous excise tax. Even if you do end up taking the distribution, however, it could have unintended consequences for your retirement if you didn't plan ahead.
“Because RMDs [required minimum distributions] may be subject to taxation, the distributions from these arrangements generally will increase the retiree’s taxable income,” Lynch says. “This may result in a higher percentage of the retiree’s Social Security benefit being taxable because the amount subject to taxation will generally increase with the addition of other sources of income.”
Ordinarily, you'd save your tax-free accounts (a Roth IRA, for example), for last. However, if your investments in taxable accounts did well, you may want to instead withdraw from a Roth IRA to keep the tax hit minimal. Criscuolo says that's a rare example, though, and that your non-taxable Roth IRA should typically be reserved for large emergency expenses like medical bills or home repairs. That way, when you tap the account, it won't affect your overall tax rate.
In any case, starting your retirement planning early and creating a long-term plan keeps the tax implications of your retirement finances in mind will go a long toward keeping surprises to a minimum. Your plan should not only factor in the taxes you might pay on your savings while you’re still working, but should allocate your investments in order to minimize your taxable income. If you can accurately predict how your retirement funding will affect your tax picture and try to plan for big withdrawals and spending that might boost you into another tax bracket, the road through retirement should be fairly well marked.
“I’ve discussed previously that Social Security is changing, and so many clients might be more focused than ever on growing their Social Security income and their personal retirement savings,” Lynch says. “The problem might be, however, that they haven't considered the tax implications or factored into their retirement finances a cushion to offset the possible tax costs.”
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.