3 Tax Tips for Retirement

When you think about retirement, what comes to mind? Vacations, sipping coffee watching the sunrise, pursuing hobbies? How about taxes? While taxes are not the most enjoyable thing to think about, they are one of Benjamin Franklin's two certainties of life, so we've come up with three tax tips for retirement.

Beware of Cliffs

There's a scene in Home Alone where Marv, one of the bumbling burglars, loses his shoes and is walking up the basement stairs, only to reach the top stair, step on a nail, and fall all the way down. The tax code is laden with these "nails". Make one wrong step, and you could wind up paying more for health insurance, losing hundreds or thousands of dollars in tax credits, or unknowingly wind up in a high tax bracket. Take Medicare premiums for instance. Your Medicare Part B and Part D premiums are actually based on how high your Modified Adjusted Gross Income (MAGI) was two years ago. For example, if in 2020 you were married with both spouses on Medicare, and had MAGI of $181,999, you'd be paying the "base" rate for Medicare Part B in 2022. However, if your MAGI was just $1 higher, your Medicare Part B and D premiums would be an extra $80.40 per month, per spouse. That extra $1 of income increased your Medicare expenses by $1,929.60! 

You should also be aware of how state tax laws are written with these income "cliffs". The state of Kansas, for example, doesn't tax Social Security income when your federal adjusted gross income is $75,000 or less. If you've got a lot of income from Social Security, this could be a huge consideration. There was a case study we worked on recently where a couple would have seen their Kansas tax bill triple from $771 to $2,304 if their federal adjusted gross income when from $74,999 to $75,001. Imagine if $2 caused a tax bill of $1,533!

Take Advantage of Low-Income Tax Years

A common misconception among taxpayers is that, when they reach retirement, they'll be in a lower tax bracket. This may be true for some, but for others, they may be painted into a corner of inescapable tax liabilities. While it's impossible to predict what will happen with your future income sources, tax laws, and how long you'll live, you can make some assumptions and map things out to the best of your abilities. Here's an income tax projection report from a client we met with this year.

Notice how income taxes fall off a cliff at retirement, because the client had brokerage accounts that would be used to cover living expenses. They would remain in this low-income tax "valley" for a period of time, before things like Social Security income and required minimum withdrawals (RMDs) from retirement accounts kicked their income back up. Moving money out of pretax accounts like IRAs or 401(k) plans into tax-free Roth accounts may not always be the answer during these low-income tax years, but it's absolutely something that should be considered annually in meetings with your financial planner or tax advisor. By converting to Roth accounts at a relatively lower tax rate, this couple could be saving tens of thousands of dollars in tax payments over their lifetime.

Know How Your Withdrawals Will Be Taxed

Not all investment accounts are treated equally from a tax perspective. For instance, if you go take $1,000 out of your checking account at the bank, that withdrawal would generally not be considered "taxable income". Take a $1,000 withdrawal from a brokerage investment account, and there may have been some tax consequences if you had to sell something that had gone up in value from when you bought it (capital gains tax). Take $1,000 from a pre-tax IRA, and you're likely to have some ordinary income tax as a result. However, a withdrawal of $1,000 from a Roth IRA may be totally tax-free. Four examples of four different types of accounts where $1,000 was withdrawn, and all four likely result in very different tax liabilities. When you are considering taking money out to start an income stream in retirement, to pay for a home remodel, or take a vacation, you should know how that withdrawal will impact your taxes ahead of time to avoid a surprise at tax time.