Retirees aren’t just at risk of losing money to market swings, they can also lose it to avoidable taxes. From missed required minimum distributions and bigger-than-necessary IRA withdrawals to a variety of other issues, small missteps can snowball into four-figure bills.
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We asked tax experts where people slip up most and how to keep more of your retirement income.
Required minimum distributions (RMDs), the mandatory annual withdrawals that retirees must take from certain tax-deferred retirement accounts, kick in at age 73 under current law.
“Forgetting to take an RMD comes with a steep penalty: The IRS charges an excise tax of 25% of the amount you failed to withdraw, though this can be reduced to 10% if corrected quickly by taking the missed distribution and filing Form 5329,” according to Sean Babin, CFA, founder and CEO at Babin Wealth Management.
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However, withdrawing too much from IRAs in one year could also bump retirees into higher marginal brackets, Babin said, because retirement account income is fully taxable as ordinary income. “When retirees face large expenses and rely solely on tax-deferred money, those extra withdrawals can easily push them into higher tax brackets if not planned carefully.”
That’s why he emphasizes the importance of tax diversification, building a healthy balance between tax-deferred and tax-free assets.
Retirees frequently trigger Social Security taxation without realizing it, according to Chad Cummings, an estate planning attorney, CPA and CEO of Cummings & Cummings Law.
“Many retirees mistakenly believe Social Security is tax-free. In truth, up to 85% of benefits become taxable if provisional income exceeds $44,000 for joint filers,” he explained. A single RMD or modest capital gain can tip the scale and cause double taxation, he noted, both on the distribution itself and on previously untaxed Social Security.
“Smart planning with Roth accounts, timing of withdrawals and tools like qualified charitable distributions can help retirees reduce taxes on their benefits,” Babin added.
Many retirees also overlook Roth conversions, which can be one of the most powerful strategies to reduce taxes over the long term, Babin said. They are especially valuable for individuals who don’t need to rely on their RMDs to cover living expenses.
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“Strategic Roth conversions done in the years before RMDs begin can help smooth out taxable income, prevent tax surprises and create tax-free income later in life,” he said. Beyond that, Roth IRAs also provide flexibility for big expenses, won’t increase Social Security taxation or Medicare premiums, and can be an incredibly tax-efficient legacy for heirs.
Retirees who sell investments or property may not realize that the gain is added to your modified adjusted gross income (MAGI). That extra income can push you into a higher long-term capital gains tax rate, trigger hidden costs like the 3.8% net investment income tax, make more of your Social Security taxable or push you over income thresholds that increase Medicare premiums (IRMAA), Babin said. “In other words, one poorly timed sale can set off a chain reaction of higher taxes.”
Planning the timing of sales, spreading them across multiple tax years or pairing them with loss harvesting and Roth withdrawals can help retirees keep MAGI in check and avoid crossing into higher tax brackets.
Retirement is often a time of downsizing and moving to a new state, yet this can lead to “dual state taxation” if you don’t understand domicile law, Cummings warned. Retirees who “snowbird” between two states, particularly from high-tax states to Florida or Texas, risk both states claiming tax residency unless they sever economic ties to the old state.
The trickiest tax for retirees is the IRMAA tax, a monthly charge on top of your normal Medicare Part B premium, according to divorce attorney, Julia Rueschemeyer.
IRMAA tax uses your income from two years earlier, starting with what you earn at 63 to set your Medicare costs at 65, she explained. The thresholds are cliffs, not gradual. Go just $1 over and you can owe around $1,000 more in premiums for the year.
She broke it down: If your income for a married couple is up to $212,000 when you are 63, your IRMAA payment will be $185 per month at age 65. Earn just one dollar over $212,000 when you are 63, and you will be paying $259 per month in IRMAA each month, so $888 for the year, based on making one dollar more two years prior.
“If your income is near one of these thresholds, do whatever you can to lower your income just below the threshold and you could save $1,000 in sneaky IRMAA taxes two years later.”
When it comes to taxes in retirement, know your thresholds, plan withdrawals across accounts and check decisions with a pro — smart tax moves now can save you thousands every year in retirement.
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This article originally appeared on GOBankingRates.com: Tax Experts: 7 Ways Retirees Accidentally Pay Too Much in Taxes
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