Foundational Tax Strategies To Keep More Money In Retirement!

Foundational Tax Strategies To Keep More Money In Retirement!

Why Planning For Taxes Is Such A Big Deal

Taxes are going to be the largest expense in retirement for most of us.  This isn’t true for everybody though. Tax preparation, done each year, is looking backwards for the prior year. So you calculate what you owe and then you pay it or get a refund if you overpaid. There is a little bit of planning you can do after the year has ended. This is much like looking in the rear-view mirror.  However, for most tax strategies to work, you have to plan ahead.  Making a future projection is very helpful with taxes.  This is like looking through the front windshield.  That helps you see how to lower your taxes and navigate through tax savings proactively. Some strategies can increase your taxes in the short term, but lower your taxes overall. I think we can agree that paying less taxes in the long-term can be beneficial.

Some of these strategies we’re going to talk about are measurable.  For instance, if you do X, then you will save Y. A lot of these strategies are a little bit more art than science.  We don’t know what the future holds. We don’t know how your investments will perform. They could grow more or less than we anticipate.

Rolling With Changing Tax Laws

Tax regulations change. In fact, the current tax law we have is scheduled to revert back to tax law from 2018 once we enter the year 2026. Obviously, it could change before then.  This depends on legislation enacted before then.  We’ll have to see how things shake out.  I am prepared for change again at some point. Certainly, change will occur over the course of a 20 or 30 year retirement.  With taxes, there are exceptions. In fact, with taxes, there are even exceptions to the exceptions.  It is important to consult a qualified tax advisor. Make sure you’re not missing opportunities to save on taxes with these strategies.  No matter how simple they seem, it’s worth your time to check for savings.

Qualified Charitable Distributions

First we’re going to talk about Qualified Charitable Distributions (QCD). This is only applies to people who are age 70-1/2 or older. This would also apply if you have parents or grandparents that are age 70-1/2 and they give money to charities. With the SECURE Act  that was passed a couple of years ago, a lot fewer people are itemizing.  Itemizing is how most people got a tax benefit for donations. A Qualified Charitable Distribution (QCD) is a strategy that lets you move money from an IRA to a charity and it’s never taxed. That’s a very powerful benefit, but you do have to be over 70-1/2 years old.

Bunching Charitable Contributions to Itemize

If you’re not 70-1/2, charitably inclined, and not itemizing on your tax return you can pursue a strategy called bunching. This lumps two years of giving into one year.  This raises your deductions above the standard deduction allowing a larger overall tax deduction.  Then you to alternate between getting the standard deduction one year and itemizing the next year. Over each two-year period, you should come out a little bit ahead.

For example, let’s say you have $18,000 of non-charitable deductions, and you give $5,000 each year. You would probably take the standard deduction each year, which is $48k every two years (yes, this ignores the standard deduction increasing slightly each year). Bunching would allow you to give $10k this year, and $0 next. So, you would get a $28k deduction this year, and $24k next year for a 2 year total of $52k in deductions.

Charitable Giving Using Donor Advised Funds

You can also use a Donor Advised Fund (DAF) instead of donating directly to a charity. This allows you to put funds aside to donate now, then decide where to donate later.  This works great with the bunching strategy just mentioned.  Donor Advised Funds are especially useful in planning out charitable giving but allow flexibility to give as needs arise.

Donating Appreciated Securities

Donating appreciated securities is very often overlooked.  Giving appreciated securities is a great strategy if you have investments that are not in a retirement account.  You can donate those appreciated holdings in kind to a charity. The charity sells it and uses the funds.  Since they’re a charity, they don’t pay any tax on it. This puts more money in your charity of choice and keeps you from paying taxes on the appreciation.  You get to deduct for the fair market value of the securities.  It really is a win-win.

Appreciated Securities Side Note

If you wanted to donate cash, but get the tax benefits of donating appreciated securities, here’s what you do.  Donate your appreciated securities, then simply replace your whatever you gave by buying more securities in your taxable account.  The net result is really no different except you now have a higher basis on that investment.  This lowers your future capital gains tax. I think this is often overlooked. Keep in mind, donating appreciated securities only applies if you have assets outside of a retirement account.  You don’t want to donate depreciated securities.

Taxes on Social Security Income

The way Social Security tax works is once your income hits a certain threshold, then a percentage of your Social Security is taxed. This is determined by adding half your Social Security benefits plus all other taxable income.  Once that amount is over $25,000 (filing single) or $32,000 (filing jointly), up to 50% of your social security benefits become taxable.  For the portion of that amount that’s over $34,000, then 85% of your benefits may be taxable.

Typically, you want to do whatever you can to stay under these limits.  Let’s say you’re married filing jointly and your Social Security benefits plus income is right around that $32,000 mark.  If you bump over that, it’s not just a tiny effect.  Your marginal tax rate may bump up because 50% of your of your Social Security benefits are now taxable. That’s not your tax rate it’s just how much of your Social Security income is taxable.  This is taxed at whatever your tax rate is otherwise. Regardless, you probably want to avoid that.  To calculate this for yourself, you can use IRS Notice 703 and IRS Publication 915.  Otherwise, contact a tax professional to help you out.

Medicare Considerations

Medicare is another one that has very important thresholds. These are for Medicare premiums you pay for Part B and Part D coverage. If you bump over these thresholds, you have to pay more in Medicare premiums. For 2021 premiums start increasing above $88,000 filing single or $176,000 for married filing jointly.  If your income is approaching those limits, whether it’s in a single year or every year, then you’re going to want to do whatever you can to avoid that.  Technically this isn’t a tax, but it feels like a tax.  It’s kind of like a phantom tax.  If your income goes through a threshold, then you pay more. Just be aware of the Medicare thresholds for increase in premiums.

The End of the Stretch IRA

As a result of the SECURE Act, which was passed in December of 2019, you can no longer “stretch” an inherited IRA.  This significantly changed the way non-spouse beneficiaries inherit retirement accounts. Previously, you could stretch Required Minimum Distributions (RMDs) over your lifetime.  If you inherited an account December 31st, 2019, or earlier you can still do that. However, for inherited from a death on 01 January, 2020, or later you’re going to want to do some tax planning.  Under the current rules, you have up to 10 years to empty the account. Depending on your situation, it could make sense to take out a little bit each year. You Might want to take all the money out in one particular year. Sometimes doing nothing for a few years first might make the most sense. It really depends.

Estate Planning After the SECURE Act

Because of the rule change, you want to try to project your taxes over those 10 years and figure out the best way to get the money out.  You want to make sure your documents account for these new rules for your heirs, whether it’s kids, grandkids, or otherwise.  The impact for a lot of people may not be that big of a deal, but the actual rule change was significant.

Realizing Income on Purpose

Sometimes it pays to use strategies where you pay more tax now so you can pay less tax later.  There are two strategies in which you would realize income on purpose: Roth conversions and capital gains harvesting.  Imagine a scenario where you’ve been working for a long time.  You have a pretty high salary and then all of a sudden you stop working. Let’s say you stop working before you start taking Social Security or required minimum distributions.  Your income basically goes to zero, but you still need to live on something during that time.  Those living expenses can from a pension or from your investments.  Most people are going to have some sort of taxable income during this time.

Because of the dip in income in this gap, your effective tax rate has the potential to be very low.  This low-income period occurs before Social Security and RMDs kick in. This presents an opportunity to do Roth conversions.  Roth Conversions are where we take a pre-tax retirement like a traditional 401k account and convert it to a Roth.  You pay ordinary income tax on that income in the year of the conversion.

However, if done correctly, you could end up paying less in taxes overall.  It can be better to get that money out of a pre-tax account as opposed to taking RMDs later. This strategy is more art than science because tax laws and your situation can change. There are other benefits to Roth IRAs that traditional IRA’s don’t have such as the Roth IRA has no required minimum distributions.  This usually makes inheriting a Roth IRA a little bit more beneficial as well. Many people will convert a little bit each year unless there’s a very good reason to do more.

Capital Gains Harvesting

The underlying philosophy for Capital gains harvesting is much the same. Capital gain harvesting means purposefully realizing capital gains in non-retirement investment accounts.  This allows you to pay a lower rate without triggering any of the other thresholds that we’ve talked about.  For example, capital gains are taxed at a lower rate than ordinary income, and may be zero if your income is low enough. This may be lower than your ordinary income tax. This can be a very powerful strategy, especially if your taxable income is under those amounts.  You are lowering future taxable gain by paying nothing now.

Avoiding Required Minimum Distributions by Working

Working in some capacity my help avoid taking Required Minimum Distributions (RMDs).  Just as a refresher, RMDs are withdrawals that you must take out of certain retirement accounts or face penalties from the IRS.  Under the SECURE Act, RMDs now start by April of the year after you turn 72.  It used to be 70-1/2. In the words of the IRS, “if your 70th birthday is July 1, 2019 or later, you do not have to take withdrawals until you reach age 72.”

If you are still working and your money is in a 401k, you do not have to take Required Minimum Distributions. If you have money in a traditional IRA, you have to take Required Minimum Distributions even though you’re still working. A strategy to avoid this is to take money from the traditional IRA and put it in your 401K. The IRS has very specific definitions of what type of employment counts to meet this requirement.   A lot of people may continue working part time, so you want to make sure you get all the benefits you can from the rules in place.  If RMDs are going to be a concern, then these strategies could save you a lot in taxes.

Roth IRA and Roth 401k RMD Differences

I mentioned Roth IRAs do not have Required Minimum Distributions, but Roth 401k plans do.  If you have money in a Roth 401k and it’s subject to RMDs, you can roll that into a Roth IRA.  This avoids RMDs and doesn’t incur any additional tax liability.  Be careful when transferring between accounts.  A direct transfer is generally going to be the best method.

Common Tax Filing Mistakes

I want to highlight a couple of mistakes that can prove very costly when doing your tax return. The first involves the Qualified Charitable Distributions (QCDs) mentioned earlier.  Any time you take money out of an IRA, a 1099R is going to be generated.  The QCD should be indicated, but sometimes this gets missed.  Whoever prepares the return must make certain that distribution is counted as a QCD.  This needs to be double-checked to make sure that money is not taxed.  

Clerical Errors on Tax Forms

The financial institution (custodian, broker dealer, et cetera) is responsible to generate the proper forms (1099-R, 1099-Q, or Form 5498).  If they make a mistake, that could have big tax consequences.  Let’s use a $100,000 direct rollover as an example.  You initiate a direct rollover from your traditional IRA to your 401k.  If that was coded incorrectly, it could look like a $100,000 fully taxable distribution.  Even though it should be a non-taxable transaction.  Big problem. You want to make sure all the documents you get are correctly coded and make sense.

Forced Itemization

It may make sense in some instances to itemize even if your total deductions are less than the standard deduction.  This strategy is called forced itemization. Many people do not itemize anymore. Depending on the state you live in, it can make sense to force itemization if you could save more on the state return.  The idea here is just doing a check to see if paying a little extra on the federal return will save you more than that amount on the state return.  This might make sense if you’re close to the standard federal deduction.  This depends on your state. It depends on your situation each year. Most tax software can quickly check the numbers for forced itemization.  Just don’t overlook this when filing your tax return.

Special Considerations for Widows and Widowers – The Widow Penalty

I’ve written an article on the “Widow Penalty” that goes more in depth, but here’s a quick overview.  If your income is about the same after your spouse dies, then you may end up in a higher tax bracket than normal.  This happens because the IRS cuts all your thresholds in half.  This can be a big problem. However, you can use a qualifying widow filing status on your return.  You can file like this for the two years after your spouse passes away.   Taxes are likely the last thing you want think about after a spouse passes away, but it does present an opportunity purely from a tax standpoint.  This may be a time to implement some of the strategies already mentioned.  Things like Roth conversions or capital gains harvesting might make sense.

State Tax Incentives for Senior Citizens

The states have various rules regarding benefits for senior citizens. They’re not uniform and define what age you’re considered a senior citizen differently. You should be aware of what tax benefits your state gives you.   Also check what age you could potentially get some of these benefits.  There could be more benefits than just income tax. This could apply to property tax, titling fees, and other lesser-known benefits. Please be sure to check your state’s rules and benefits.

When Married Filing Separate Makes Sense

In rare circumstances it can make sense to file married filing separate. A big reason is if one spouse has student loans.  Many people in retirement don’t have student loans, but it’s not unheard of. If you have student loans, then you should complete an analysis to see if this makes sense.

Having significant medical bills is the biggest reason I see to file married filing separately.  Sometimes it makes sense to file separately because of how medical bills can be deducted.  This is a simple analysis that can be completed using tax and financial planning software.  A qualified tax professional shouldn’t take long to get you an answer on if this makes sense or not.

Closing Thoughts and Steps Forward

A lot of these strategies are kind of tactical.  They are actions you can take now to affect your tax situation. They will either apply to you or not.  The strategies that may have the most impact are the Roth conversion and capital gains harvesting, which can be more art than science.

Getting A Projection To Start From

We can do projections to serve as a starting point.  Checking whether you can fill up your lower marginal tax rate buckets will tell you if it makes sense.  We don’t know what the tax laws are going to be. We know they’re probably going to change. Those future changes could benefit you – or not. There is no way to really know.  Usually there’s a way to implement these strategies a little bit at a time. Pay a little bit more now and hopefully it works out for you in the future.  That’s where I focus for the big-ticket strategies.  All the other strategies may help you a little bit year to year.

Reference Resource Download

You can access the download that goes through these strategies in more detail here.  You can use it as a reference guide for later. This article is educational in nature and should not be considered specific advice. You should always consult a tax advisor, attorney, or a financial planner like me about your specific situation. Provision Financial Planning is a registered investment advisor in Maryland, Alabama, and other states where exempted.  Additional information and disclosures are available at provisionfinancialplanning.com.