By Charles Sherry, M.Sc. and Mike Kastler, MSF
A popular quote from one of our founding forefathers, Benjamin Franklin in 1789:
Our new Constitution is now established, and has an appearance that promises permanency; but in this world, nothing can be said to be certain, except death and taxes.”
Taxes can’t be avoided, but they should be minimized. Many a client has frowned (polite description) when they discover they have overpaid on their taxes. Almost nothing can be worse than wandering into these unknown tax traps, especially if you are in retirement where every penny counts.
Taxes–federal, state, local, sales tax, property tax, gasoline tax, payroll tax, tolls, fees, taxes on capital gains, dividends and interest, gift tax, inheritance tax, and cigarettes and alcohol. There has even been a rising chorus that is calling for a special tax on junk food.
Yes, Ben Franklin nailed it. We can’t escape taxes. But perhaps we can learn about some of these tax traps and put some strategies in place to avoid or minimize them. If you have already retired, you are aware that taxes don’t end when retirement begins. For those who are nearing retirement, it is important to recognize, plan for, and minimize the tax bite that awaits.
We could spend hours reading about and discussing tax traps. This article is intended only as a high-level summary. Its purpose is to help provide awareness and perhaps help you avert some of the potential surprises. Planning for tax outlays doesn’t reduce the discomfort that goes with paying Uncle Sam. However, preparation can reduce the tax bill and eliminate unexpected surprises.
With all of that in mind, below are just a few of the tax traps you should be aware of, especially in retirement. Please keep in mind that there are many more details and the only way to know for sure how the changes affect your bottom line tax liability is to work closely with your tax preparer or CPA.
Potential Tax Traps in Retirement
Tax Trap 1: Estimated Quarterly Tax Payments May be Required
If you have never been self-employed, you are accustomed to having federal, state (if your state has an income tax), and payroll taxes withheld from each paycheck. When you stop working, there are no more W-4s to complete and no one is withholding taxes for you. But that doesn’t absolve you of your year-end tax liability.
You can have taxes withheld from your pension, social security, or IRA distribution. For example, if you have yet to file for Social Security, you may choose to withhold 7%, 10%, 12% or 22% of your monthly benefit for taxes. Or you may decide not to have anything withheld. Same goes for your other sources of income.
Many people have other sources of variable income such as business income. If you are one of them, you need to account for that income as well and make additional estimated tax payments each quarter.
The goal is to withheld enough taxes from each source of income or set up estimated quarterly payments that cover all your sources of income. Otherwise, you may face a penalty. It sounds complicated, but you don’t have to go it alone. Tax planning is a part of Retirement Planning. Seek out help from your Financial Advisor, CPA, or other qualified professional.
Tax Trap 2: Social Security May be Taxed
If you file as an individual and your combined income (adjusted gross income + nontaxable interest + half of your Social Security benefits is between the 2018 threshold of $25,000 and $34,000, you may have to pay income tax on up to 50% of your benefits. If the total is more than $34,000, up to 85% of your benefits may be taxable.
If you file a joint return and you and your spouse have a combined income that is between $32,000 and $44,000, you may have to pay income tax on up to 50% of your benefits. If combined income is more than $44,000, up to 85% of your benefits may be taxable. For more information, see SSA.gov Benefits Planner: Income Taxes and Your Social Security Benefits.
Currently, Michigan does not tax Social Security benefits, but MI does tax pensions and other retirement benefits. If you are thinking of relocating to another state, be aware that some states do tax Social Security benefits. Such states include Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont and West Virginia.
Tax Trap 3: The Social Security Earnings Test
Although not a tax per se, your Social Security benefit could be reduced if you are working, exceed certain income limits and collecting Social Security prior to your Full Retirement Age (FRA). You will need to inform the Social Security office in advance so that they can deduct the proper amount from your benefit. I will not get into the formula here, but be aware that this scenario can happen. You will need to consider very carefully about taking Social Security early if you are planning to continue working prior to reaching your FRA.
The good news is that if the Social Security Earnings Test does apply to you, the amount that gets deducted from your monthly benefits will get credited back to you at a later date when you reach your full FRA. There is no Earnings Test penalty if you are working past your FRA.
Social Security optimization is another key component of Retirement Planning that needs thoughtful consideration. But again, you need not analyze all the scenarios on your own. Seek help! Your Social Security claiming strategy is a permanent decision. There is no “do-over.”
Tax Trap 4: The IRA Required Minimum Distribution (RMD)
No joking matter – Failure to take the required distribution from your IRA accounts could subject you to a 50% penalty! This also applies to SEP IRA, Simple IRA, 401(k), profit-sharing, 403(b), 457(b) and other retirement plans.
RMDs are minimum amounts that such plan account owners must withdraw annually by 12/31. The first years’ payment is due by April 1 in the year after you reach 70½ years of age. If retirement occurs after age 70½, then the RMDs begin in the year in which you retire. The amount of the RMD is calculated by a formula based on your age, an IRS distribution factor, and your account balance as of 12/31 of the previous year. I know, this is just insanely complex.
It gets worse. If the retirement plan account is an IRA or the account owner is a 5% owner of the business sponsoring the retirement plan, RMDs must begin once the account holder is 70½, regardless of whether he or she is retired (source: IRS Retirement Plan and IRA Required Minimum Distributions FAQs).
Please note that RMDs are not required from a Roth IRA. (Yeah, something simple).
If you expect to have large RMDs that could push you into a higher tax bracket, it may be beneficial to begin taking distributions prior to 70½. Or, you could convert some of your IRA into a Roth, which will help shelter gains and future distributions from taxes. You pay a tax upfront, but it’s one strategy that can help minimize taxes long-term.
Tax Trap 5: The Hidden Cost of Selling Your Primary Residence
Downsizing can generate cash and reduce your daily expenses. But beware that it may also trigger a tax liability.
If you’ve lived in your primary residence for at least two of the last five years prior to selling, you can exempt up to $250,000 of the profit from taxes if you are single and up to $500,000 if you are married. If you are widowed, you may still qualify for the $500,000 exemption (IRS: Publication 523 (2017), Selling Your Home).
The sale may also trigger the 3.8% tax on investment income. It’s a complex calculation that can ensnare single filers who have net investment income and modified adjusted gross income above $200,000 and $250,000 for married filers. (IRS: Questions and Answers on the Net Investment Income Tax).
Your decision to sell may not be strictly governed by the tax code. However, it’s important to understand the tax ramifications. Strategically timing your other income streams may be beneficial if the sale of your home will trigger a taxable event.
Mitigating the Tax Trap Exposures
As stated in the beginning, taxes can’t be avoided. But it sure helps if we can mitigate some of the tax exposure. Knowing about these tax traps (there are others) is a good first step. Strategizing to overcome them and other techniques requires a lot of thought and tax planning, especially during your retirement years. You generally will not have the income to make up for any mistakes along the way!
There are other methods to lower your taxes, including charitable donations. How we structure retirement income, your investments, and distributions from retirement accounts can help to reduce the tax burden. Your Retirement Plan should include strategies to mitigate these tax traps.
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