When you’re working, taxes are pretty straight-forward and predictable. You get your W2 paycheck, and taxes are withheld, with qualifying retirement contributions giving you tax deductions. Pretty simple! However, when you retire, taxes get much more complicated. In fact, many retirees fall into unforeseen tax traps, which can lead to unneeded interest and additional penalties. In this article, Chris from REAP Financial takes you through the top retirement tax traps and how you can avoid them. Keep reading to learn more!
As we’ve discussed, taxes are more complicated in retirement. But, there’s good news too! You have more control over your taxes in retirement than you in any other time of your life. Oftentimes, retirees don’t know how to maximize their tax filing process. This results in many people paying more taxes than they need to or more penalties and interest throughout the years. In your working years, taxes primarily revolve around W2s, which are easy and simple. When you enter retirement, you’re dealing with a whole portfolio, likely consisting of CDs, money market accounts, cash, brokerage accounts, Roth IRAs, 401Ks and IRAs, HSAs, and more! To make it more complicated, all these account types are taxed differently.
Luckily, you get to choose which ones you want to live on and when you’ll draw on which accounts. These choices help you optimize for the best possible tax outcome. Even so, you’ll want to be careful not to fall into common retiree tax traps, described below.
Top Retirement Tax Traps Retirees Face
1. Taxes on Social Security and Medicare Premiums
Although this was not always the case in the past, you are almost guaranteed to pay taxes on your Social Security. In 1983, limits were established to mark the maximum income to avoid paying taxes on your Social Security. Those limits were established in the 1980’s, and they have never gone up since then, despite everything else going up, including Social Security checks. As a single-filer, you have to keep your income under $25,000 a year to avoid paying tax on your Social Security. As a married couple, your yearly income has to be below $34,000. Both of these numbers put you at a poverty level. Half of your Social Security check will count towards income, so it would be very hard to stay under those limits. This means you will likely pay tax on your Social Security benefit.
Medicare premiums will also come out of your Social Security payments. One special consideration for Medicare premiums is the IRMAA surtax. This Medicare surtax inflates depending on your income, meaning you will pay more for Medicare premiums the more income you have. If you go beyond the IRMAA limits, such as following the sale of a home, you may be impacted by IRMAA. If you have to pay IRMAA many years throughout your retirement, it can have a big impact on your taxes throughout retirement.
2. Net Investment Income Tax (NIIT)
The Net Investment Income Tax applies to families making over $200,000 a year as a single filer or over $250,000 a year for a married couple. If you make above these limits, anything above the limit will be accessed by the NITT, which is 3.8%. Whether you expect to make over these limits in just one year or in multiple years, you need to know what your expected incomes will look like throughout retirement. That additional 3.8% can create enormous impacts on your taxes.
One factor that really creates this issue for many retirees are required minimum distributions. Many individuals get to retirement with large retirement accounts and are subsequently required to take large minimum distributions, which can push them above those NIIT limits. These RMDs often push retirees up a tax bracket and into NIIT territory. For this reason, it is important you’re aware of all the elements of your retirement income and how they’ll flux over the years, so you can plan for it.
3. Widow’s Penalty
As the name suggests, we see the Widow’s Penalty creep up when someone loses a spouse. Since tax laws are structured to favor married couples, filing as a single person can impact your taxes dramatically. When someone loses a spouse, we expect to see a big shrink in their wealth once they have to file single. This is because the brackets create more taxation, despite potential losses of income, through the absence of the deceased spouse’s pension or Social Security payment.
Generally, we see that a widow’s budget doesn’t change drastically after the loss of a spouse, but tax brackets shift a great deal. This means your income will face higher taxes, face potentially higher Medicare premiums, and you’ll be taxed more on your Social Security.
4. Estimated Tax Payment Penalties
Estimated Tax Payment Penalties are assessed when you don’t evenly pay estimated tax payments throughout the year. In pre-retirement, taxes are withheld from W2 pay on a regular basis, so when tax season arrives you expect a refund. In retirement, if you’re taking money from your IRAs and 401Ks without withholding tax, that can create interest and penalties, not to mention a big tax bill at the end of the year. This one is easily avoided. If your distributions don’t come from pre-tax accounts, you can set up withholding on them, so you avoid estimated tax payment penalties.
You’ll also want to consider interest earned on your savings, such as CDs or money market accounts. Although you’re likely reinvesting the interest or dividends, it is still considered income. This is also the case for mutual funds and brokerage accounts. This activity can create ordinary qualified dividends as well. If you have these investment types in your portfolio, you will have to pay estimated tax payments on them in retirement. For example, if you sold company stock or sold highly appreciated stocks in February, your first estimated tax payment would be April 15th, followed by June 15th, September 15th, and finally January 15th.
Another example: if you made a large Roth conversion in October, you’d be required to make an estimated tax payment on that by January 15th of the next year. These things are often overlooked, thus creating issues. If you notice you have some of these penalties and interest coming out of a tax cycle, you can file a Form 2210. If you’re over the age of 62, this form can grant you a once-in-a-lifetime abatement of the penalty and interest. Make sure you examine your 1040 this tax cycle if you’re over 62. If you see any penalties coming, that can be a nice way to avoid paying these penalties and interest.
Plan and Optimize Your Retirement with REAP Financial
If you want to learn more, REAP Financial, an Austin-based retirement planner, has plenty of resources. Our Top Tax Tips guide is incredibly helpful for avoiding these pitfalls and optimizing your taxes in retirement. To get your free copy, send us an email at retire@reapfinancial.com with “Tax Tips” in the subject line. We’ll make sure this valuable guide gets to your inbox, so you can optimize your taxes in retirement.
Main Office Address:
REAP Financial
9414 Anderson Mill Rd #100
Austin, TX 78729
Phone: 512.249.7300
