On February 2, 2022

Tax planning changes in retirement

By Kevin Theissen

It’s not uncommon for people to pay more in taxes than anticipated because our tax system treats various income types differently and has tax and penalties that many are unaware of.

One way to consider the stages of retirement could be: first, your pre-retirement or work and saving years, usually before age 50 to 60. Next, early retirement, ages 60-70, when many are going strong. Then middle retirement, ages 70-80 when some slow down. And finally, late retirement of 80 plus years.

Some of the surprises that people run into in retirement include inflation, longevity, expenses and healthcare. People often view their future costs in today’s dollars and don’t forecast how those costs will grow with inflation. Many live longer than they expect, which requires more money. Many also underestimate how much they need to maintain their pre-retirement standard of living and this includes how much they will likely need to spend on healthcare costs.

Here are some ideas to avoid surprises in your retirement years:

Idea 1: You must know what your after-tax retirement savings picture looks like before retiring.

If you save $1 million in your 401k, it’s not really $1 million. Taxes must be paid. If you’re already retired, you’ll want to start evaluating next year’s potential tax bill before you start withdrawing your assets in the new year.

Idea 2: Social Security and Medicare have tax traps that you need to plan for.

IRA withdrawals can cause the taxation of your social security benefits and potentially push you into a higher marginal tax rate. Higher income (for example when you withdraw assets) can cause potentially hundreds of dollars a month in extra Medicare premiums.

Idea 3: You must plan how and when you will use taxable, tax-deferred, and tax-free assets to manage your income and tax brackets efficiently.

You may want to consider starting to draw down IRAs early, so that your required minimum distributions (RMDs) won’t have as large an effect on Social Security taxation and Medicare premiums. Also consider filling in your tax bracket in lower income years through Roth conversions or selling appreciated stock, to take advantage of a lower tax rate. You could also think about donating your RMDs directly to charity to avoid paying income tax on the distributions, through what is known as a qualified charitable distribution (QCD).

Idea 4: Organize your assets for your family’s benefit with thoughtful estate planning.

If you have a terminal illness, make sure to think about step-up basis strategies. There are multiple ways to leave IRAs as an inheritance; you need to make sure your heirs get the best and easiest transfer. Long-term care is a major concern for many people. You need to plan how you will fund this likely expense, and still leave an inheritance for your heirs.

Because your tax situation can change throughout retirement, you need to anticipate how and when you tap assets to cover your expenses. By understanding the variety of taxes you will face at different stages you’ll be able to manage your actions so you can pay as low a tax rate as possible.

Kevin Theissen is the owner of HWC Financial in Ludlow.

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