Many people meticulously plan to reduce taxes during their working years but overlook the complexities of tax planning in retirement. Income taxes are often your largest lifetime expense! Retirees face unique challenges such as Medicare premium surcharges, managing withdrawals from various types of accounts, charitable strategies and taxation of Social Security. Here’s what you need to know to manage your taxes effectively once you retire.

Social Security Tax Planning

It’s a common misconception that Social Security benefits are not taxable. In reality, the taxation of your Social Security benefits depends on your overall income in retirement. Understanding the interaction between Social Security tax brackets and your income tax brackets is crucial to avoid unexpected high-tax-bracket spikes, potentially pushing you into a 40% marginal federal tax rate.

When to Claim Social Security

Deciding when to claim Social Security benefits is a significant decision that affects your retirement tax planning.  You can claim your Social Security benefit as early as age 62 for a reduced amount or defer until age 70 to get an increase of 8% per year up to age 70.

When you decide to claim Social Security can also impact your tax-planning opportunities each year. For instance, if you choose to delay 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 (like a Roth IRA) through a conversion. 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 Income-Related Monthly Adjusted Amount (IRMAA) Surcharges

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. Enrolling in Medicare and selecting the appropriate gap coverage are paramount to having a complete financial plan. But as with 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. However, there are a few brackets that vary depending on whether you file a joint or single return. If your adjusted gross income is even $1 above a particular 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 breaking points 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 the income reported on your tax return two years prior! So Medicare premiums in 2025 will be based on the income reported on your 2023 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!

Income Taxes in Retirement

Just because you’re no longer working does not mean that income taxes go away. In fact, your income may not actually be that much lower once you stop working. Most people save all their lives in pretax retirement accounts, like a 401(k) or an IRA. The deal with the government is that you get a tax deduction when you put the money in but have to pay tax on it later when you take it out. These withdrawals are taxed as regular income and subject to the same tax brackets as income earned from work. 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 that’s 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 73 (75 for those born in 1960 or later) 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 to do so are important aspects of a retirement tax plan strategy.

State Income Taxes

Don’t overlook state income taxes. Each state has unique rules regarding the taxation of retirement income and knowing these can help you plan. Massachusetts does not tax Social Security benefits or most state and federal pensions but does tax most other types of retirement income.

Investment Income and Capital Gains

Besides retirement account income, another common source of funding for retirees is their investment accounts. It is not uncommon to see retirees shift a larger portion of their assets from growth-producing to income-generating investments. This can be risky from a tax standpoint.

First, realize that there is a difference between investment income and capital gains. Capital gains get favorable treatment in the tax code. Currently, there are three capital gains brackets: 0%, 15%, and 20%. Interest, pensions, nonqualified dividends, and annuities are taxed at normal income tax rates, which may be 22%, 24%, 32% or higher. Qualified dividends are taxed at (often) lower capital gains tax rates. If you shift money from assets that grow in the form of capital gains (stocks) to ones that distribute interest income (bonds), you may find that your income from investments increases in retirement at less-favorable rates. Many people don’t realize just how much they are hurting their after-tax returns by moving their assets from stocks to bonds in their taxable investment accounts.

Second, depending on your income, there may be an opportunity to “capital gain harvest.” Strategies like capital gain harvesting, where you deliberately realize gains in a tax-advantaged manner, should be considered alongside other income to optimize your tax situation.

Lastly, some states, like New Hampshire, have an interest and dividends tax. If you live in New Hampshire and move more investments into income-producing vehicles, you may be subject to the dividends and interest tax you weren’t subject to in previous years. Of course, income derived from assets held in a retirement account is still not subject to this tax, only interest and dividends in nonretirement accounts are. Also, this tax is currently phasing out; 2024 will be the last year it is assessed.

Estate Taxes

Estate planning remains crucial, especially with fluctuating federal exemption limits and varying state laws. Also, the amount currently exempt from estate tax is scheduled to be cut in half after 2025!

Many states, like Massachusetts, have their own estate tax limits, and their exemption may be much lower than the federal limit. For Massachusetts, the estate tax kicks in for estates starting at $2 million. While that may seem like a large estate, it’s important to remember that it also includes the value of your home. With real estate prices skyrocketing in recent years, if you own a home and have even a modest retirement account and investment portfolio, there is a good possibility that you may owe estate taxes in Massachusetts.

There are ways to mitigate estate taxes owed, such as through a gifting strategy to other individuals or by making a charitable donation. However, there are pitfalls for the unwary, so beware of the gift and generation-skipping taxes when implementing these.

Roth Conversions

Strategic use of Roth conversions during low-income years can help reduce your total lifetime taxes paid by shifting money from tax-deferred to tax-free accounts. This not only lowers future required minimum distributions but also potentially reduces future tax rates on withdrawals.

If you retire before age 70 and can delay claiming your Social Security benefit 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 73 (75 if you were born in 1960 or later), so you won’t be taxed on extra income from your IRAs yet. This provides a unique opportunity for many retirees to fill up lower tax brackets by accelerating income from 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 IRMAA surcharge 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 breaking 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 such that you enter a new Medicare surcharge threshold.

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

With income tax rates currently at historic lows and the federal deficit at a record high, we think it’s unlikely tax rates will drop more in the future. But that is a risk one takes when implementing Roth conversions.

Tax-Efficient Withdrawals

Deciding which accounts to withdraw from each year can maximize your tax efficiency. Blending withdrawals from taxable, tax-deferred, and tax-free accounts can help manage your tax bracket each year more effectively. This will generally consist of pretax accounts (e.g., IRAs and 401(k)s) that are taxed upon withdrawal, tax-free accounts (e.g., Roths and health savings accounts) that are not taxed upon withdrawal, and taxable accounts (e.g., 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 not to 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 money 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 gains 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 working with 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 is 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 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 what types of accounts certain types of investments should be placed in, depending on the account type.

Pretax accounts

It’s generally best to put high-income-producing investments, such as bonds, into these accounts. That is because interest and nonqualified dividends are taxed at ordinary income tax rates and are the least tax-favorable. Putting these in an IRA or a similar account defers the tax until you remove the assets from the account.

In addition to that, income-producing assets like bonds tend not to grow as much as stocks do over the long term. Of course, past performance does not guarantee future results. But historically, with less growth from these assets, you may reduce your future “tax bomb” by keeping high-growth assets in other, tax-free accounts.

Tax-free accounts

Since we’re emphasizing bonds in pretax accounts, we’re going to prioritize high-growth assets, such as stocks (especially small cap stocks), in tax-free accounts. You want the assets to grow as much as possible since you don’t need to pay tax on any growth later. Because 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 whenever possible because capital gains have a more favorable tax treatment than other types of income. Specifically, these accounts should hold any international investments you have (such as mutual funds or exchange-traded funds) 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 either. However, whether it is worth using this type of bond depends on your tax bracket, as bonds usually have a lower interest rate because of the additional tax benefits. In general, you want to be in the highest tax bracket (currently 37%) before that makes sense.

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

Proper planning can ensure that your retirement savings help achieve your long-term goals, whether leaving a legacy to heirs or contributing to charities. Understanding how different assets are taxed upon inheritance can guide you in deciding which assets to convert, gift, or leave as donations.

Inheritance

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

Recent legislation made significant changes to the taxation of retirement accounts. The Setting Every Community Up for Retirement Enhancement (SECURE) Act and SECURE Act 2.0 were enacted in 2019 and 2022, respectively. With this legislation came significant changes to how people inherit retirement accounts. No longer can they spread out small distributions over their lifetime. Instead, inherited retirement accounts need to be emptied within 10 years of the year following the death of the original owner. 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.  Although Roths still need to be withdrawn within 10 years, the money still comes out tax-free.

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 your heirs as well. If their tax brackets are 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) to avoid taxation at your death. This eliminates the need to pay tax on these investments for you or your heirs, as your cost basis resets to the value on the date of death.

Depending on your investment management strategy and goals, 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 such positions before passing them to your heirs.

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 lifetime to reduce these taxes. Stay tuned for future blogs on this topic!

Charitable Giving

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

Unlike people, charities don’t pay taxes. There are several ways to make tax-efficient gifts to charity. We will only cover a few of them here.

The best accounts or portions of accounts to leave to a charity with a beneficiary designation are pretax ones, like IRAs. This is because an IRA can be a tax bomb for an individual but, again, charities don’t pay taxes, so they would get to keep the entire account.

Speaking of IRAs, after you turn 70½, you can do a qualified charitable distribution (QCD). This allows you to take up to $105,000 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. 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 its appreciation. If you are one of the few individuals who are still able to itemize deductions, this counts as a QCD 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. 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 use 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 tax planning, or retirement planning in general, please reach out to our team.