Retirees – Do This Now to Lower Next Year’s Tax Bill

With every new chapter in life comes anticipation for what lies ahead. The prospect of new opportunities can be exhilarating. However, amidst this excitement, it is essential to consider financial aspects, such as taxes. Retirement, despite its allure, demands due diligence, especially regarding taxes. A significant portion of your retirement savings will be subject to taxes, which is why having a tax strategy in place can help. Tax planning should be proactive rather than reactive to ensure you are not caught off guard by a hefty bill.

A financial advisor can help you understand the various taxes you could be subjected to in retirement and what you can do about them right now to lower your next year’s tax bill. This article will focus on how retirees can reduce taxes to ensure they get to preserve more of their savings.

Below are five steps retirees can take to reduce their taxes for the coming year:

1. Plan your Required Minimum Distributions (RMDs)

When you have money saved up for retirement in an account that you have not paid taxes on yet, like a traditional Individual Retirement Account (IRA) or 401(k), the government wants you to start taking some of that money out each year once you reach a certain age. They call this your RMD. To figure out how much you need to take out each year, you need to divide the total amount of money in your retirement account by a number that represents how long the government expects you to live based on your age. This number comes from a table made by the Internal Revenue Service (IRS) called the Uniform Lifetime Table. As you get older, the government wants you to take out a higher percentage of your retirement savings each year because they figure you will not live as long, so they want you to use that money sooner rather than later. The RMD is calculated for each separate account. So, in case you have more than one retirement account, you have to figure out the RMD for each account separately.

If you do not withdraw your money from your traditional retirement accounts as per the IRS schedule, you will be subject to a penalty amounting to 25% of the amount not withdrawn. There is no way to avoid this penalty. However, you can lower it to 10% if you make a withdrawal within the next two years. Even then, you do lose a chunk of your savings to a penalty that could have been used for your retirement goals. Therefore, it is important to understand your RMD schedule and plan your RMDs beforehand to ensure you do not incur any penalties, withdraw enough money to cover your needs, and minimize your taxes.

While the retirement account balances are increasing, it is important to understand that they will likely increase the distribution value in 2024, leading to a higher tax bill.

Here are some strategies you can use to optimize your RMDs in 2024:

a. Use a retirement calculator: You can use a retirement withdrawal calculator to determine your withdrawal needs for the coming year. The Financial Industry Regulatory Authority (FINRA), the American Association of Retired Persons (AARP), and many other public and private organizations offer online calculators that can be used to determine the RMD amount for your withdrawals. This can help you be prepared and know your annual RMD value and taxability for the coming year. Based on these factors, you can compute your monthly income needs.

b. Hire a financial advisor: It is recommended that you hire a financial advisor to understand the taxability of your withdrawals. Financial advisors can help you understand the right strategy for making withdrawals and ensure you optimize your RMDs to avoid penalties. They can help you understand the tax rate for 65 years old and older,the general retiree group that makes RMDs, so that you can comprehend the impact of taxes on your withdrawals. Even though RMDs are mandatory after the age of 73, you can still start withdrawing your money before that. The minimum age for withdrawals is 59.5 years. A financial advisor can help you devise a withdrawal schedule that aligns with your age and financial needs. They can also suggest converting to a Roth account if that makes more sense for your individual tax situation.

c. Automate your RMDs: Once you know how much money you should be withdrawing this year, you can set up automatic withdrawals and seamlessly set up a suitable withdrawal process. Automated withdrawals eliminate human errors, like procrastination and forgetfulness, and ensure you make the required withdrawals on time.

d. Withdraw more than the recommended RMD: The Tax Cuts and Jobs Act, which was passed in 2017, brought about various changes to tax rates and rules. However, many of these changes are set to expire at the end of 2025. When that happens, tax rates could potentially go up again unless new legislation is passed to extend or modify these changes. If the Tax Cuts and Jobs Act provisions expire, it is estimated that taxes could increase by around $400 billion per year starting in 2026. This potential increase in taxes could have significant implications for taxpayers across age groups.

Given the possibility of paying higher taxes in the future, it may make sense to withdraw more of your savings now and pay a lower tax rate than a higher one in the future. Even if you exceed your recommended RMD for the year, you can still withdraw more funds to save tax in the future when rates may be higher. However, this decision is more complicated than it seems, and a thorough evaluation is recommended. You may consult a financial advisor to understand how this move aligns with your individual situation.

2. Move to a Roth IRA

Moving to a Roth IRA can be an effective way to lower your overall taxes. Roth IRAs are not taxed on the withdrawals made in retirement, as you have already paid tax on this money in your working years. So, all your RMDs are non-taxable after the age of 59.5 years. You can move funds from a traditional 401(k) and IRA to a Roth IRA. There is no limit on the conversion, and you can choose to move all your money or parts of it in batches to the new Roth account. Once your money is in a Roth account, you do not owe any future taxes on it. This can eliminate paying taxes on these funds for the rest of your retirement.

However, you must keep in mind that the conversion attracts tax. When you convert to a Roth IRA, you pay tax in the year the conversion is made. One way to minimize this is by not rolling over all your funds at once but making smaller rollovers over time. This limits your taxes for a particular year and distributes the liability. Another practical approach can be to turn over the funds right after you retire. Your income may drop in retirement, especially if you retire before the age of 73. Your mandatory RMDs will not start yet, so your overall income for the year will be low. You can choose a year where you have a relatively low income to transfer your funds. This way, you can lower your overall tax output.

3. Maintain a balance between traditional and Roth accounts

It might be prudent to balance your withdrawals, drawing from both taxed and untaxed funds. You can also consider allocating some of your money to a Roth account without entirely shifting all of your savings. The remainder can be retained in a traditional 401k/IRA account. This can be helpful because it gives you flexibility when it comes to managing your taxes in retirement.

With this setup, some of your retirement funds will be taxed upon withdrawal, while others will not be taxed at all. You can withdraw funds from your traditional 401(k) account, subject to taxation, and simultaneously withdraw from your Roth account, free from taxes. This strategy has the potential to reduce your overall tax liability and promotes tax diversification.

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4. Lower your Social Security tax

Your Social Security benefits are subjected to federal taxes. But whether you are taxed depends on your combined income. If your combined income is above the base amount, you will owe some tax on your Social Security income. Here is the formula to calculate your combined income:

Combined income = Adjusted Gross Income (AGI) + Nontaxable interest + 1/2 of Social Security benefits

a. For single filers, heads of household, or qualifying widows or widowers with a dependent child: The limit for 2023 and 2024 on Social Security income is $25,000.

b. For joint filers: The limit for 2023 and 2024 on Social Security income is $32,000.

c. If you are married and file separately: You will likely have to pay taxes on your Social Security income regardless of the limit.

Federal tax on Social Security income can go up to as much as 85%. In addition to this, you may also owe state taxes on your Social Security benefits. For the 2023 tax year, the following 11 states tax Social Security benefits:

1. Colorado
2. Connecticut
3. Kansas
4. Minnesota
5. Missouri
6. Montana
7. Nebraska
8. New Mexico
9. Rhode Island
10. Utah
11. Vermont

Lowering your Social Security tax can have many advantages and also impact Medicare. At 65, you are eligible for Medicare, which is health insurance provided by the government. But Medicare is not entirely free. You typically pay for it every month, and the amount you pay depends on your income.

The Income-Related Monthly Adjustment Amount (IRMAA) is an extra fee added to your Medicare premium if your income is above a certain threshold. Now, if your taxable income goes over this threshold, you will have to pay even more for Medicare. This extra charge can be significant, sometimes increasing your Medicare payment by up to 339%. So, to keep your Medicare costs as low as possible, it is essential to keep your taxable income low. That means being strategic about managing your income sources and minimizing your tax bill.

There are some strategies to lower your Social Security tax in retirement. You can start by evaluating all your income sources and understanding the tax implications of all your retirement incomes. This can help you strategically time your withdrawals to minimize taxes by withdrawing more from other retirement accounts before claiming Social Security benefits. This method reduces your taxable income during that period. Additionally, it helps to delay claiming your benefits. Delaying claiming your Social Security benefits, especially if you have other sources of money, can potentially increase your benefit amount and reduce the taxable portion of your benefits. In the meantime, you can draw down other assets, such as 401(k)s and IRAs, to cover your expenses.

You can also consider contributing to tax-advantaged retirement accounts like a Roth IRA or Roth 401(k). Contributions to these accounts are made with after-tax dollars, so you have already paid taxes on the money before depositing it into the account. Qualified distributions from Roth accounts are tax-free, which can help minimize the taxable portion of your Social Security benefits. More of this is discussed in the point above.

If you are wondering if retirees get any tax breaks on Social Security benefits, you must know that there are some exemptions. Members of a religious group may be exempt from taxes if they are opposed to receiving Social Security benefits during retirement, when diagnosed with a disability, or after death. Additionally, nonresident aliens working in the U.S. for a foreign government are also exempt from Social Security taxes.

5. Educate yourself on how you are taxed

It is important to educate yourself on the various areas of taxes and how they apply to your unique situation. This can help you plan well and prepare for what lies ahead. You can start by understanding the tax rates and income thresholds. Here is a table of income tax rates for the 2024 tax year:

In addition to understanding the tax brackets, you must also know of investments that can help you save money. For instance, bonds can lower your overall tax liability.  When you invest in federal bonds, you do not have to pay state or local taxes on the interest you earn from them. Similarly, when you invest in state or municipal bonds, you usually do not have to pay state or city taxes on the profits you make from them. This can make these types of bonds attractive to reduce your overall tax burden.

Moving to a tax-friendly state can also help. This can lower property tax, Social Security state tax, and others and help with overall tax optimization. Aiming for long-term capital gains can also be a tax-friendly strategy than short-term capital gains, as the tax rate on the former is relatively lower.

Short-term capital gains are taxed as per your ordinary income. Long-term capital gains tax rates for 2024 are given below:

To conclude

Proactive measures can not only help you make more prudent and timely decisions but also lower the financial stress associated with taxes. Acting sooner eliminates the possibility of making last-minute errors, missing deadlines, and basing decisions on incomplete information. It is advisable to consult a tax professional, such as a financial advisor, when planning and filing taxes. Financial advisors can assist you in understanding the various tax-saving provisions available and help you select the ones that align with your retirement goals.

Use WiserAdvisor’s free advisor match service to find experienced financial advisors who can help you with tax optimization in retirement. All you have to do is answer a few simple questions based on your financial needs, and the match tool can help connect you with 2 to 3 advisors best suited to meet your financial requirements.