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The Importance of Retirement Tax Planning – Why Tax Planning in Retirement Is Just as Important as When You’re Working

One of the largest, yet often overlooked, expenses we all pay over our lifetimes are taxes: income taxes, Social Security taxes, Medicare taxes, property taxes, sales taxes, estate taxes, state taxes, and the list goes on and on. Not to mention the nearly endless list of various tax credits, brackets, surcharges, and the like that can significantly alter the total amount of taxes due.  

In financial media, there is significant chatter about saving for retirement and utilizing ways to reduce your taxable income during your working years. But what often gets neglected are the discussions surrounding taxes in retirement, which, in many cases, are even more complex than when you’re working. With Medicare premium surcharges, Social Security brackets, estate taxes, required minimum distributions, and withdrawal decisions from tax-deferred, tax-free, and taxable accounts, juggling all these different items can be incredibly challenging.  

Many people also often fail to consider their lifetime goals and how taxes are a significant aspect of them. Whether your goals are to provide an inheritance, give to charity, or enjoy the fruits of your labor in your golden years, the tax considerations of the path you choose should not be overlooked. Here’s what you should know about tax planning in retirement. 

Social Security Tax Planning 

It comes as a surprise to many retirees to find that, more often than not, their Social Security is taxable in retirement. Like most aspects of our tax code, whether or not your Social Security is taxable and what the taxable amount can be are based on certain thresholds.  

As of this writing, if you file as married, none of your Social Security is taxable if your modified adjusted gross income (MAGI) is below $32,000, 50% is taxable income if MAGI is between $32,000 and $44,000, and 85% is taxable if MAGI is over $44,000. For individual filers, the brackets are below $25,000, between $25,000 and $34,000, and over $34,000.  

The highest amount of your Social Security income that will be taxed is 85%. This is not to be confused with normal tax brackets, however. Your Social Security is not taxed at 85%, but 85% of your Social Security income can be subject to tax.  

Example: Mike files as single, has a MAGI of $50,000, and is in the 22% tax bracket. Out of his total income, $10,000 comes from Social Security. Since his MAGI is above $34,000, 85% of his Social Security is taxable, or $8,500 worth of income ($10,000 * 85%). Since he’s in the 22% tax bracket, the total tax on his Social Security income is approximately $1,870 ($8,500 * 22%).  

Since the Social Security brackets and income tax brackets are separate, but related, some retirees can find themselves in high tax-bracket spikes because of how these calculations work. This can cause someone who is technically in a low tax bracket to experience an over 40% marginal federal tax rate! Not monitoring your tax planning in retirement can cause many individuals to pay more tax on their Social Security income than expected. 

When to Claim Social Security 

Since Social Security is taxable to many retirees, the decision of when to claim Social Security is important to consider as well. Many people choose to wait until their full retirement age (67 for most future retirees) to get their full benefit. However, you can claim as early as age 62 for a reduced benefit or defer until age 70 to get an increased benefit of 8% per year. There is no benefit to waiting past age 70, so make sure to claim by then at the latest! 

In addition to the decision of when to claim Social Security, you may also need to decide on whose earnings record you are claiming. If you’re married, you have the option to claim your own or one-half of your spouse’s benefit. If you’re divorced and have not remarried, you may also claim on an ex-spouse’s record, as long as you were previously married for at least 10 years, and they are currently claiming their benefits. Also, if your spouse has passed away, you can claim the higher of their record or your own.  

When you decide to claim Social Security can also impact your tax-planning opportunities in a given year. For instance, if you choose to delay Social Security until age 70, you may be in a lower tax bracket in those years after retirement. This may be a fantastic opportunity to move money from a tax-deferred account (like a 401(k) or an IRA) to a tax-free account (Roth) through conversions. We will discuss this in more detail later, but what you should know is that when you claim Social Security can have a material impact on your retirement tax planning and overall retirement success in general.  

Medicare Premium Surcharges - Income Related Monthly Adjusted Amount (IRMAA) 

One of the most common health insurance choices for retirees in the United States is Medicare. Within Medicare, different parts cover various aspects of our medical system. In addition to this, a retiree may also want to choose a Medicare “gap” policy that covers the gaps in traditional Medicare coverage. For more details, we recently wrote a post about Medicare, the different plans, and applying for coverage beginning in 2022. Enrolling in Medicare and selecting the appropriate gap coverage are paramount to a complete financial plan. But, like Social Security, there are additional tax implications for retirees.  

Although not technically described as a “tax,” Medicare premiums for parts B and D are based on a retiree’s income. The higher your income in retirement, the more you will pay for coverage. There are a few brackets that vary depending on whether you file a joint or single return. If your adjusted gross income (AGI) is even $1 above a threshold, you are subject to the higher rate for that year. These Medicare premium increases are all or nothing, unlike the marginal impact of regular income tax brackets. Managing your income to keep it below certain breakpoints is a crucial retirement tax-planning strategy. 

To complicate Medicare premiums and the tax planning surrounding them further, the premiums are not based on the current year’s income, but on your income reported on your tax return two years prior! So, Medicare premiums in 2022 will be based on the income reported on your 2020 tax return. For many retirees, the tax planning for Medicare premiums does not start when you can begin using it at age 65, but two years prior when you’re 63! 

Thankfully, there are some exceptions to these surcharges. One of the most common ones is for stopping work or reducing your hours. So, many who retire at age 65 shouldn’t be subject to the surcharge because they can claim their income was higher because they were still in their working years. However, in order to receive this exception, you would have to file a Medicare Life-Changing Event Form; otherwise, you won’t get the reprieve. For a complete list of other exceptions, you can view this link.  

Let’s Talk About Income Taxes 

Just because you’re no longer working does not mean that income taxes go away in retirement. In fact, your income may not actually be that much lower in your golden years. Most people save all their lives in pretax retirement accounts, like a 401(k) or IRA. The deal with the government is that you get a tax deduction when you put the money in but need to pay tax on it later when you take it out. These withdrawals are taxed as regular income subject to the same tax brackets as income earned from work. Well, when retirement finally rolls around, many find that they did such a good job saving that pulling out the money puts them in a tax bracket similar to when they were working.  

Of course, this retirement income is in addition to other income sources like Social Security, investment income, and pensions. The money in retirement accounts can only be delayed for so long. The year in which you turn 72 is when you are forced to take a minimum amount of money out of these accounts or face a stiff penalty.  

With the complexity of income taxes and the various sources of income, planning how much to take out of these accounts and when are important aspects of a retirement tax plan strategy.  

Don’t Forget About State Income Taxes 

In addition to formulating a plan for federal income taxes, it’s also important to consider state income taxes. Many states, including Massachusetts, impose state income taxes to fund their coffers. Income from IRAs, investments, interest, and other sources is still subject to the usual income tax. A benefit for some retirees, however, is that Massachusetts does not tax Social Security benefits

Each state has its own unique tax rules. Knowing what income will be subject to tax in your state and what potential new credits you may qualify for are important pieces in a complete retirement tax plan.  

Investment Income 

Besides retirement account income, another common source of funding for retirees is their investment accounts. Each individual’s investment plan and risk tolerance will vary, and as such, the investments in their portfolio with it. However, it is not uncommon to see retirees shift a larger portion of their assets from growth-producing to income-generating ones. There are a few key components to consider if deciding to do this.  

First, realize there is a difference between investment income and capital gains. Capital gains get favorable treatment in the tax code. Currently, there are three brackets: 0%, 15%, and 20%. Most investment income, like interest and dividends, is taxed at income tax rates. As discussed before, income tax brackets are higher than the capital gains brackets (with the exception of qualified dividends, which are taxed at capital gains rates). If you shift money from assets that grow in the form of capital gains (stocks) to ones that distribute income (bonds), you may find that your income from investments increases in retirement and at less favorable rates.  

Second, depending on your income, there may be an opportunity to capital gain harvest. The media talks a lot about capital loss harvesting by taking investment losses to offset gains. However, depending on your tax situation and long-term plan, it may make sense to deliberately realize capital gains at no tax. Deciding to do this should be analyzed in conjunction with possibly taking more IRA income. 

Lastly, some states, like New Hampshire, have a special interest and dividends tax. Unlike Massachusetts, New Hampshire only taxes income on interest and dividends over a certain threshold. If you live in New Hampshire and move more investments into income-producing ones, you may be subject to dividends and interest tax when you weren’t in previous years. Of course, income derived from assets held in a retirement account is still not subject to this tax, just interest and dividends in nonretirement accounts.  

Estate Taxes 

While not technically a tax in retirement, estate taxes are important to consider when it comes to legacy planning, which is often done in retirement. Estate taxes used to be a much larger concern for retirees, but in recent years, and especially after 2018, the exemption limits have exploded. For 2022, the exemption amount per person is $12,060,000 (double that for married individuals)! This makes it so only a minority of people will be subject to federal estate taxes. 

However, it is important for retirees to keep an eye on this because there is talk of these limits reducing. Many retirements will last 20 years or longer, and as recently as the year 2000, the estate tax exemption was only $675,000. While most won’t be subject to these taxes today, there is a possibility that if the laws change, many people will be subject to this tax in the future.  

Although the federal limits are currently enormously high, that is not necessarily true for state estate taxes. Many states, like Massachusetts, have their own estate tax limits, and their exemption may be much lower. For Massachusetts, the estate tax kicks in for estates starting at $1,000,000. While that may seem like a large estate, it’s important to remember that it also includes your home. With real estate prices skyrocketing in recent years, if you own a home and even a modest retirement account and investment portfolio, there is a good possibility that you may owe estate taxes in Massachusetts.  

Retirement Tax-Planning Strategies 

As you can see, there are numerous tax-planning considerations for retirees. Part of our job for clients of Milestone is to help our clients reduce their total lifetime taxes paid. Much of that has to do with navigating the various tax brackets, income sources, and surcharges associated with a retiree’s income. But, in addition to the dollars and cents, the best tax-planning strategies need to consider what your goals are. We’ll touch on some goal-specific planning shortly, but there are some general tax-planning strategies that apply to most retirees.  

Roth Conversions 

A common tax-planning strategy for retirees is implementing Roth conversions. This moves money from pretax retirement accounts to a Roth, which will grow tax-free going forward. Retirement is usually a good time to consider this because, at least initially, there is a good chance that your income will be lower.  

If you retire before age 70 and are able to delay claiming Social Security until then, you’ll have no (or less) income from work and no additional income from Social Security yet. Also, required minimum distributions (RMDs) don’t start until age 72, so you don’t have to be taxed on extra income from your IRAs yet either. This provides a unique opportunity for many retirees to fill up lower tax brackets by accelerating income on their IRAs.  

When planning to do Roth conversions, there are a few key tax components to consider:

  1. What is your current tax bracket?
  2. What is your projected future tax bracket?
  3. Where are the Medicare Surcharge (IRMAA) brackets? 

The balancing act is projecting where your future income may be based on current tax laws and if it is expected to be higher in the future, taking more income now. However, when doing that, keep in mind that at certain break points you’ll be subject to additional Medicare costs. The key is to convert enough income to fill up lower brackets, but not too much where you’re just entering a new Medicare surcharge threshold.  

In addition to filling up lower tax brackets, another benefit to doing Roth conversions is that it will reduce your future required distributions. The way these distributions are calculated is by taking your year-end IRA balance and dividing it by a predefined number so a higher percentage of the account is taken every year. The lower the balance, the less your RMD. Doing Roth conversions right can have a double tax impact – lower marginal rate now and less at a higher rate later.  

Of course, tax laws are always changing, and there is a potential that tax rates will be lower in the future than where they are now. However, with income tax rates currently at historic lows, we think it unlikely they will drop more in the future. But that is a risk when conducting Roth conversions.  

Tax-Efficient Withdrawals 

Another key tax consideration for retirees is which accounts to supplement their income from. As financial planners, we advocate having diversified investment portfolios. In addition to that, we also tout the benefits of having tax-diversified portfolios to give you options of where to pull money from. This will generally consist of pretax accounts (IRAs, 401(k)s) that are taxed upon withdrawals, tax-free accounts (Roths, health savings accounts (HSAs)) that are not taxed on withdrawals, and taxable accounts (investment/brokerage accounts) where investment income is taxable to you and any sales may be subject to capital gains.  

Navigating which accounts to pull money from and when can be challenging. As with orchestrating Roth conversions, you’ll want to consider which tax bracket you’re in now and what your future tax situation may look like. For instance, maybe you need extra money this year to do a home renovation but expect to not need to pull much additional money in the future. It may make sense to fill up a certain tax bracket with IRA withdrawals and take any additional from Roth accounts.  

Retirees will also want to manage their investment income, specifically capital gains. As discussed before, there may be an opportunity to take capital gain income at a 0% tax rate. This can be incredibly advantageous, especially if needing to rebalance a portfolio, and may be better than converting extra IRA money in a given year.  

Lastly, when operating in investment accounts, you will also need to evaluate what to sell when money is needed. When you purchase something in a taxable account, the purchase price creates the cost basis. If you sell the investment for more than the basis, you realize a capital gain; if you sell for less, a capital loss. Deciding what to sell is a crucial factor when managing your investment portfolio in retirement.  

Tax-Efficient Location 

On the topic of tax-prudent investment management, deciding which investments to place in which types of accounts can have a significant impact on your lifetime taxes. There are general guidelines for which types of investments should go where depending on the account type.  

Pretax accounts: 

It’s generally best to put high-income-producing investments in these accounts, such as bonds. That is because interest and nonqualified dividends are taxed at income tax rates and are the least tax-favorable. Putting these in an IRA or similar account prevents you from being taxed on that income while it’s in the account.  

In addition to that, income-producing assets like bonds tend not to increase in value as much over the long term as stocks do. Of course, past performance does not guarantee future results. But, historically speaking, with less growth from these assets, you’ll have less pretax money to pull from later on while still providing the stability of bonds in a well-diversified portfolio.  

Tax-free accounts: 

Since we’re emphasizing bonds in the pretax accounts, we’re going to prioritize high-growth assets like stocks in these tax-free accounts. We want the assets to grow as much as possible since we don’t need to pay tax on any growth later. Since these accounts have different tax characteristics, it often makes more sense from a tax perspective to emphasize certain assets in specific accounts and not use the same investments for all account types.   

Taxable accounts: 

These accounts should emphasize stocks when possible because capital gains have a more favorable tax treatment than income. Specifically, these accounts should hold any international investments you have (like mutual funds or exchange-traded funds (ETFs)) because some investment income from those funds may be subject to foreign tax. If you pay foreign tax, you may be able to claim a foreign tax credit on your tax return. This potential credit is lost if these investments are held in a retirement account where taxes are not paid on investment income. 

Also, depending on your tax situation, it may be appropriate to include municipal bonds in this account type. Although they also generate income, this income is usually not subject to federal income taxes and possibly not state taxes. However, whether it is worth using this type of bond depends on your tax bracket because bonds usually have a lower interest rate because of the additional tax benefits.  

Overview:  

Obviously, the most important aspect of an investment plan is to have a well-diversified portfolio based on your risk tolerance, regardless of which accounts you have and the balances in each. However, there are often opportunities to maximize the tax efficiency of where you put certain investments while staying within the frame of a diversified portfolio. 

Legacy Planning 

At the end of the day, the purpose of all this retirement tax planning is to help our clients reach their goals. Efficient tax planning can save retirees a significant amount of money over their lifetime, allowing them to enjoy more of their money rather than paying Uncle Sam. However, beyond enjoying the money yourself, which is a perfectly acceptable goal, many individuals have legacy planning desires for either their heirs or to assist specific charities. When legacy planning is considered, you’re no longer just looking at taxes over your lifetime but also taxes beyond your life. Here are some additional tax considerations surrounding these goals. 

Inheritance  

A common goal is to provide an inheritance for children or even grandchildren. But which assets you give them, and more importantly, where they come from, can have an enormous impact on their tax situation.  

Relatively new legislation, the Setting Every Community Up for Retirement Enhancement (SECURE) Act, passed at the end of 2019. With it came significant changes to how people inherit retirement accounts. No longer can they spread out small distributions over the course of their lifetime. Instead, inherited retirement accounts need to be emptied after no later than 10 years. For children inheriting accounts in their working years, what was once a tax inconvenience can now be a tax bomb! 

Prior to the SECURE Act, it was common financial advice to have people inherit Roths because even if inherited, the money still comes out tax-free. This is even more true now since the SECURE Act. Although Roths still need to be withdrawn in 10 years or sooner, it won’t have a negative tax impact on those inheriting the account.  

If this is a goal of yours, it may mean that you convert more money to Roths now, even if your personal future tax brackets may be lower. This is because you are no longer looking at only your tax brackets, but those of the future generation as well. If their tax bracket is likely going to be higher than yours, it may make sense to convert more of your pretax accounts.  

Besides retirement accounts, there is still a rule in place that allows for a step-up in basis. What this does is allow investments that have unrealized capital gains (gains that you haven’t sold yet) not to be taxed at your death but inherited at their current value. This eliminates the need to pay tax on these investments for you or your heirs (at least at the stepped-up price).  

Depending on your investment management, it may make sense to avoid selling investments with large embedded gains so that your heirs will receive them with an increased basis. This also works the other way – if a position is at a loss, it gets stepped down. To avoid this, it’s important to try to sell these before passing them to heirs. 

There have been substantial talks to remove the step-up in basis, but it hasn’t gone through yet. This is something to continue to monitor if it relates to your legacy planning. 

Lastly, although you’re gone, any estate taxes will reduce the amount of the assets your heirs inherit. There are certain estate-planning strategies you may be able to implement during your life to reduce these taxes. These go beyond the scope of this post but are something to discuss with a qualified estate-planning attorney or financial advisor to determine if these strategies may be appropriate for you and your goals.  

Charitable Giving 

Along with providing an inheritance, some individuals may also want to provide for charities they care about after their passing. Generosity is a wonderful goal, but there are tax implications to consider in order to provide your gifts in the most tax-efficient manner.  

Unlike people, charities don’t pay taxes. The best accounts or portions of accounts to leave to a charity are pretax ones, like IRAs. Speaking of IRAs, after you turn 70.5, you are allowed to do what’s called a qualified charitable distribution (QCD). This allows you to take up to $100,000 a year tax-free from your IRA if the money is being sent directly to a qualified charity. What’s even better is that a QCD also counts toward satisfying your RMD for the year. This can potentially be a great option for charitably inclined individuals, especially since most people can no longer deduct their charitable contributions because of the increased standard deduction.  

Appreciated stock is also great for charities as well. Instead of giving cash to a charity, you can give an appreciated asset. Since it was a donation, you never sold the stock and thus don’t pay the capital gains tax on the appreciation. If you are one of the few individuals who are still able to itemize deductions, this counts as a charitable donation for that too. However, gifts of stock are subject to different limits, so you may not be able to deduct the full amount in a given year.  

Wrap-Up 

Whew. If you made it to the end of this post, I commend you. Who knew there was so much to cover when it came to retirement tax planning? Those hoping their tax situation would get simpler when they finished punching the clock for good may be disappointed.  

In retirement, there are usually many different tax brackets, all conflicting with one another. Understanding how to navigate them can be tricky, but doing so effectively can significantly reduce your total lifetime taxes paid. This frees up more money for you to enjoy or to pursue other goals in a more tax-efficient manner.  

Although there is a lot to consider, you don’t have to do it alone. If you need assistance with your tax planning or retirement planning in general, please reach out to our team.