Getting Ready to Retire? Know the Tax Implications

Even if you’ve done all your own taxes throughout your working life, it’s still a good idea to turn to a professional when you retire. Why? Because the rules are different in the golden years when your income is typically lower. You may also be drawing out of tax-deferred accounts and on assets loaded with capital gains and/or losses.

A professional can help you nab every potential deduction and tap accounts in accordance with the laws to help you avoid a bigger-than-necessary tax bite from the IRS. The general rule is to draw from your taxable assets first, then the tax-deferred, leaving the Roth individual retirement accounts (IRAs) as the last resort and the potential go-to fund if you have a heavy-income year, for example, because you sold property.

And remember this: Your income may be lower, but your tax bracket may not. The IRS looks at adjusted income, not gross income, and you may no longer have the same tax credits you did when you were gainfully employed. You also may not be spending as much daily on potential deductions—think lunch, transportation, software, etc.—that you did while employed. Sure, that’s less expenditure but also fewer deductions.

Here’s a quick list of things to think about:

1. Your monthly Social Security check could be taxable. That’s a big shock to many retirees, and while no one pays federal income taxes on more than 85% of Social Security benefits, it can still put a crimp on a happy retirement. Many investors have other income besides that monthly average Social Security check of $1,827 in 2023, according to the Social Security Administration, or $21,924 annually. Employment wages, self-employment earnings, savings, CDs, traditional IRAs, traditional 401(k)s, 403(b)s, 457s, pensions, etc. can all add up to income. Roth IRAs and Roth 401(k) accounts are generally not taxable, so withdrawals usually do not increase your income. When it comes to Social Security benefits, the IRS looks at what’s called your “combined income.” That’s your adjusted gross income plus nontaxable interest plus one-half of your Social Security benefit. If you’re filing as an individual, and your combined income is between $25,000 and $34,000, you may have to pay income tax on up to 50% of your benefits. If it’s more than $34,000, that tax jumps to 85% of your annual benefits. Joint returns are at levels between $32,000 and $44,000, and above. Remember that your Medicare Part B premium is automatically deducted from your Social Security checks, so the amount you get each month will be reduced for this premium. And your premiums rise based on higher income levels—even more reason to understand how your income will affect your net spendable Social Security.
2. Your deductions change. You’re no longer educating yourself or the kids, who have also started their own adult lives and have long been off the tax-deduction list. And if you listened to most retirement planners, your mortgage has been paid off, so that hefty tax deduction no longer exists.
3. Tax-deferred accounts, like a traditional IRA, will cost you, and it can be painful. Once you turn 72, there’s the required minimum distribution (RMD) that’s taxed as ordinary income. And that’s for every tax-deferred account, not just traditional IRAs but also 401(k)s or 403(b)s. IRAs and 401(k)s that you inherit also have RMD requirements. When you draw those RMDs, it’s considered gross income. And if you choose to ignore RMDs or simply forget about one or two accounts, you’ll get smacked with a 50% penalty for the amount not taken.
4. Your RMDs swell the longer you live. Hardly seems fair, does it? But as your life expectancy dwindles, at least by most formulas, you’re required to take out a little more each year, with some exceptions. There are a number of online RMD calculators to give you ballpark monthly estimates, but consider this: At 72 today, the RMD on a $70,000 account is roughly $2,500 annually. Assuming that account earns about a 6% return and you didn’t withdraw an extra-large amount at any time, at 85 years old, you’ll be looking at a RMD of about $5,600—an amount that could easily push you into a higher tax bracket.
5. Distributions from your tax-deferred accounts can slay some of the fun of having watched them grow over the years. Withdrawals from investments like stocks, bonds, and mutual funds are smacked with income taxes on gains and pre-tax contributions, which is why it’s often better to start taking income in retirement from your taxable accounts before your tax-deferred accounts. Roth IRA or 401(k) savings can be particularly beneficial because they allowing you to tap into spendable income without having to pay taxes on your withdrawals in retirement.  
6. Things change—eventually. At any given time, during any given year of your retirement, Congress can rewrite the tax rules—and expect filers to comply. You pay your professional to stay on top of these changes.

We do have some recent good news for seniors:  
On August 19, 2022, President Biden signed the Inflation Reduction Act, which requires the federal government to negotiate prices for some drugs covered under Medicare Parts B and D starting in 2026. This new negotiating power expands to more drugs each year, is estimated to save Medicare $98.5 billion through 2031, and is expected to also reduce Part D premiums for seniors. 

And starting in 2023, the law requires drug companies to pay rebates to Medicare if prices rise further than inflation for drugs used by Medicare beneficiaries. And by 2025, the law will cap annual out-of-pocket drug costs for Part D enrollees to $2,000, which could be particularly helpful for seniors with catastrophic health issues like cancer, hepatitis C, or multiple sclerosis.

In addition to reducing Part D premiums, the new Inflation Reduction Act is projected to dampen the rise in Medicare Part B premiums too. Remember that this will be very impactful because Part B premiums are automatically deducted from your Social Security checks.

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The information presented is for informational and educational purposes only. Content presented is not an investment recommendation or advice and should not be relied upon in making the decision to buy or sell a security or pursue a particular investment strategy.