Whether you’re soon to be retired or are newly retired, it’s important to understand how taxes will change for you. Recent tax code changes and legislature are also affecting 2019 tax season, so we’re sharing a few things you should know.
Retiree Taxes and Tax-Deferred Accounts
If you’re officially retired, you’re not making money from work. That doesn’t mean you’re not earning an income, however. You’re earning income from your investment accounts, possibly Social Security, and any number of other sources. And while having income without working is ideal, you do need to understand the taxes associated with those income sources.
Some income sources, like Social Security, may not be taxed (although this depends on your state’s Social Security tax laws) or taxed at a reduced rate. You may also be withdrawing money from an IRA, inheritance funds, or personal savings. In the event that you’ll be withdrawing money from a tax-deferred retirement account, you’ll need to pay income tax on that income.
Because you’re not earning money from traditional employment, you may be in a lower tax bracket. However, you’ll still need to pay the appropriate amount of taxes on any money you withdraw from your tax-deferred accounts we mentioned above.
When you withdraw that money, you’ll be paying taxes on that income. Because it’s not a traditional employment position, you’ll need to indicate how much you want withheld and that money is automatically sent to the IRS. If you don’t withhold enough money, you’ll see the additional amount you need to pay when you file your taxes next year.
The good news is: when you stop earning money from employment and begin receiving Social Security, you have a window where you can take advantage of a lot of tax strategies. This can save you money on your 2019 taxes (and every year, really), but it all depends on having the right withdrawal strategy in place before retirement. Your strategy should also factor in required minimum distributions.
Knowing Your Required Minimum Distributions (RMD)
Required minimum distributions are minimum amounts that you must pull from your retirement accounts after a certain age. While each person’s RMD may differ based on IRS calculations, the laws are changing a bit thanks to the new SECURE Act.
The SECURE Act, which stands for “Setting Every Community Up for Retirement Enhancement,” is changing the RMD age from 70.5 years to 72 years. Once you reach that official age, there are required minimum distributions you must take. This means you now have about 1.5 more years to evaluate your current accounts and to revise a plan that helps you limit your tax liability.
It’s important to evaluate your RMD calculations, understand your tax-deferred amounts, and calculate your tax liability from there. Before the age of 72, you’ll want to create a better plan that helps you remain in a lower tax bracket, while still maintaining the income you need to thrive in retirement.
Read more about the SECURE Act here.
What Can You Do About RMDs, Tax-Deferred Accounts, and Higher Tax Brackets?
Depending on the tax bracket you are in after (or even as you approach) retirement, it’s important to look at tax-deferred accounts to see if it’s possible to withdraw, spend, or transfer some of those funds to limit tax liability. Here are just a few ways that might be possible, depending on your situation.
A ROTH Conversion
In the event that most of your funds are tied up in an IRA or 401(k), it may be possible to transfer some of those funds into a ROTH IRA, which means you’ll pay taxes on that income based on your lower (non-employed) tax bracket. To do this, you’ll need to transfer funds out of your IRA, pay taxes on the amount, and then put it into a ROTH IRA. Then, when it comes time to start pulling your minimum amounts, you’ll have a pre-taxed income that you can supplement with Social Security, other funds, etc. to keep taxable income low.
Of course, you’ll need to speak with your financial advisor to make sure this scenario fits your situation.
A Donor-Advised Fund
If you’re charitable in nature and would be open to donating money, it’s possible to reduce your taxable income by creating a donor-advised fund. By doing so, you actually receive a tax deduction, which most people don’t receive anymore (just a standard deduction is most common now). If you stack your giving, you qualify for the itemized deduction and can receive the full deduction in one year.
To reap the tax benefits, you could “donate” a lump sum in a single tax year, rather than giving a certain amount over time. That “donation” then goes into a donor-advised fund, which can accrue value from investments over time. Depending on the nature of your donor-advised fund, the value would get donated over time to the causes you or the organization that holds your account supports.
It’s also possible to do something similar with existing IRA values — without creating or contributing to a donor-advised fund. With your IRA, you can take any amount and give that straight to charity (without receiving any of it) and avoid the tax liability.
Understand how the SECURE Act will impact your taxes
After January 1, 2020, the SECURE Act will undoubtedly have an impact on your tax liability in retirement. As we’ve mentioned, the SECURE Act is affecting your RMD age, pushing it back by 1.5 years. This is great for those who reach the age of 70.5 after January 1, but for those who’ve already reached that age, RMDs stay the same.
SECURE will also change the rules regulating inherited IRAs: most people will now need to distribute the full value of an inherited IRA over the course of 10 years. Prior to this act passing, you could spread the value of an IRA out over the course of the beneficiary’s life, reducing their tax liability. This change should guide how you and your spouse design your beneficiary plan, as well as your plan in the event that you receive an inherited IRA from a family member or loved one.
We discuss the SECURE Act much more in-depth here.
In Conclusion: Work With a Tax Professional and Your Financial Planner
There’s no denying that the nuances of retirement tax can be overwhelming. If you haven’t planned for your retirement withdrawal strategy and you’re approaching or entering retirement, it’s important that you do so now. It’s entirely possible to reduce your tax liability while maintaining a secure income level in retirement with the right support. Working with a tax professional who can help you understand your options when filing is, of course, a great first step. You should also work with your financial advisor or Certified Financial Planner™ to make sure you’re eliminating as much tax liability as possible.