3 Ways to Minimize Your Tax Bill in Retirement
By: Stacey Nickens
You’ve worked hard your whole life to build up your retirement nest egg. You save for healthcare expenses, housing renovation needs, and even a travel budget. However, as you are settling into a slower retirement lifestyle, you realize that you’re paying a hefty tax bill that’s eating into your savings. To avoid getting to this point, let’s discuss some common reasons retirees face a high tax bill as well as strategies you can employ to minimize your tax burden.
Many retirees face a significant tax bill due to their required minimum distributions, or RMDs. After turning 72, retirees must withdraw a certain percentage of their retirement account funds each year. All tax-deferred retirement accounts face RMDs, including IRAs and 401(k)s. RMDs are subject to your ordinary income tax rate, and if you don’t take the full RMD, the IRS can hit you with an additional penalty tax equivalent to 50% of the amount that should have been withdrawn. RMDs can also increase taxes on your Social Security benefits and on Medicare.
To reduce your RMD tax burden, consider saving in a Roth IRA. You pay taxes on Roth contributions upfront, such that withdrawals from a Roth IRA are tax-free. Because of this, Roth IRAs are not subject to RMDs. You can either make regular contributions to a Roth IRA or you can convert a traditional IRA into a Roth IRA. A Roth conversion will require you to pay taxes on the amount converted, so you could consider converting small portions of your IRA each year.
Retirees may also lose income to Social Security taxes. Your Social Security benefit becomes taxable when your provisional income crosses a certain threshold. Provisional income is equal to 50% of your Social Security benefit plus additional income from job earnings, pensions, annuities, capital gains, dividends, and interest. Roth IRA withdrawals do not count towards provisional income. As a single filer, you will owe taxes on up to 85% of your Social Security benefit if your provisional income exceeds $25,000. As a joint filer, you will owe taxes on up to 85% of your benefit if your provisional income exceeds $32,000.
To avoid provisional income taxation, it may be prudent to delay claiming Social Security. For example, if you plan to continue to work in your 60s, you could wait to claim your Social Security benefit until you have fully retired and until your provisional income is accordingly smaller. Additionally, those converting funds into a Roth IRA may want to delay claiming their benefit until the conversion is complete. Not only will delaying your claim increase your monthly benefit, it could also reduce the amount that your benefit is taxed.
Finally, you may face taxes on your Medicare benefits in the form of income-related monthly adjustment amounts (IRMAA). This monthly adjustment acts like tax that increases your monthly Medicare premiums. The size of your IRMAA, and whether you pay IRMAA at all, depends on your adjusted gross income reported on your tax return two years prior to the date when you would start paying IRMAA.
To avoid or reduce IRMAA, you could make a qualified charitable distribution from a traditional IRA. Qualified charitable distributions reduce your taxable income and could accordingly reduce or eliminate any Medicare premium increases. (Keep in mind that IRMAA is based on your income from two years prior. You would accordingly need to plan in advance to employ this strategy.) Qualified charitable distributions can also count as your RMD for the year, reducing your RMD taxes.