Retirement is supposed to be "the golden years," but make a few tax-planning mistakes along the way and your nest egg can become a golden egg for the government.
Unfortunately, taxes don't get less complicated when you retire. In fact, they get more baffling. Adding to the challenge is that our ability to make clear financial decisions declines as we age.
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Here are three common tax pitfalls that seniors run into and suggestions on how to avoid them:
1. Forgetting to Take or Miscalculating Your Minimum Required Distribution (MRD)
In general, the deal with retirement accounts is that you can't touch the money until you’re old enough to retire (usually age 59½). Touching it earlier than that usually comes with a huge penalty from the IRS.
Many people reach age 59½ and don't want to start taking money out of their retirement accounts. Maybe they're not ready to retire or they don’t want to burn through the money. Usually this is fine, but sometimes people forget that their accounts have minimum required distributions.
An MRD virtually forces you into retirement because it requires you to start taking money out of your retirement accounts at age 70½. The government enforces the MRD in order to collect taxes. (And that MRD tax rate is usually the same as your income tax rate.)
There are two big exceptions to the MRD rule, though. One is Roth IRAs, which do not have an MRD attached. The other is that you don’t have to take withdrawals if you’re still working.
MRD rules are complicated, but the important things to remember are that you need to make sure you take your distributions, and you need to take the correct amount—otherwise, the IRS will charge a 50% penalty on the portion of the withdrawal you didn’t take. IRS Publication 590 will help you calculate the right MRD amount, but your financial institution should be able to do it for you.
Most of the time, calculating how much you have to withdraw is based on everybody’s bet on how long you and your beneficiary are going to live. The three life expectancy tables that can be used include:
Joint and Last Survivor Table – For owners whose sole beneficiary is a spouse who is 10 years younger or more.
Uniform Lifetime Table – For owners who do not list a spouse as a beneficiary or whose sole beneficiary is a spouse less than 10 years younger.
Single Life Expectancy Table – For beneficiaries.
So what's the pitfall? Many retirees aren't informed about the MRD, which ends up costing them 50% of the withdrawal each year they miss it. Be sure to understand how your financial institution is calculating your distribution.
2. Forgetting to Plan for Taxes on Your Social Security Income
One of the most common questions retirees have is whether social security benefits are taxable. The easy answer to this question is "maybe."
The first step is to look at the benefits you received during the calendar year, which appears on the Form SSA-1099 you receive from the government.
Use that to calculate your combined income:
Combined Income = Adjusted gross income + nontaxable interest + ½ of Social Security benefits
If you file an individual return and your combined income is between $25,000 and $34,000 ($32,000 to $44,000 for joint filers), up to 50% of your Social Security income is taxable. If your combined income is over $34,000 ($44,000 for joint filers), up to 85% of your benefits are taxable. If you’re married and file separate returns, 85% of your Social Security income is probably taxable. You can find more details on how to calculate how much of your social security benefits are taxable here.
In general, if your only income during the year was Social Security, none of it is likely taxable. But if you receive any other income -- even if that income isn't normally taxable -- it could result in some Social Security benefits being taxed.
3. Blowing off Estate Planning
Estate planning can be complex and intimidating, especially if you have a decent net worth. But if you blow it off, you might cost your heirs thousands of dollars or leave them with a tax bill that could force them to sell the very things you want them to have the most when you’re gone. That's why it's important to hire a professional estate planner.
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One important task that your estate planner will handle is to make sure you designate beneficiaries for your assets. Generally, when you die, all of your assets can pass to your spouse without taxation. But to avoid probate, set up a will and a trust that specify clearly what you want done with your holdings. You can save your heirs hundreds of thousands of dollars and protect cherished assets or heirlooms just by setting up a will and trust, as well as designating (and regularly reviewing) beneficiaries on your retirement accounts, life insurance policies and any other financial assets.
Here are a few suggestions that can help you avoid those tax pitfalls:
Consolidate Those Old Accounts
First, if you're not working anymore, consolidate your old 401(k) accounts into IRAs. Leaving a 401(k) or other retirement plan at your old company is unnecessary. In fact, when it's time to start living off of these funds, taking money out of a 401(k) is often more difficult than taking money out of an IRA. Rolling a 401(k) over into an IRA is an easy process and is usually not taxable.
Annuitize Your IRA
If you like the idea of guaranteed income for life, you might want to turn your IRA into an annuity. Here, your financial institution looks at your life expectancy and calculates a monthly payment that theoretically ensures that you won’t outlive the money in the account.
Of course, the longer the guaranteed payout, the lower the monthly payout will be—which is why you can also instruct your financial institution to annuitize your IRA for just a certain time period.
Set Something Aside for Taxes in Retirement
Many people assume that not having a job means not having to pay taxes. This is the pitfall that seniors run into with their retirement accounts, because they don't realize that taxes are due on the distributions or on their Social Security income.
When you start taking distributions, you should receive a 1099-R showing the amount. Set aside some money to pay for the taxes on these distributions—usually they're taxed at ordinary income tax rates.
The Investing Answer: Unfortunately, when it comes to financial planning, retirement can actually make things more complicated. Like anything in life, planning ahead can save you headaches and in this case, hundreds of thousands of dollars. The cost to avoid these pitfalls is small, but the savings can be substantial for you and your family.
Hiring a professional tax preparer and/or estate planner can help ensure you've covered all of your bases.