Tax planning is a critical component of a successful retirement strategy. While many retirees focus on growing their savings, it’s equally important to consider how taxes will impact your retirement income. Unfortunately, many retirees make common tax mistakes that can significantly reduce their hard-earned savings. By understanding these pitfalls and taking proactive steps to avoid them, you can protect your financial security and enjoy a more comfortable retirement. Here are the top five tax mistakes retirees make and how to avoid them.
Mistake #1: Not Understanding Required Minimum Distributions (RMDs)
One of the most common tax mistakes retirees make is not fully understanding Required Minimum Distributions (RMDs). Once you reach age 73, the IRS requires you to start taking RMDs from your traditional retirement accounts, such as 401(k)s and IRAs. The amount you must withdraw is based on your account balance and life expectancy, and these withdrawals are subject to income tax.
Failing to take your RMD on time can result in hefty penalties—50% of the amount that should have been withdrawn. To avoid this, it’s crucial to know when your RMDs begin and how much you need to withdraw each year. Consider working with a financial advisor to develop a strategy that minimizes the tax impact of RMDs, such as withdrawing more in low-tax years or converting portions of your traditional IRA to a Roth IRA before RMDs start.
Mistake #2: Ignoring the Tax Impact of Social Security Benefits
Many retirees are surprised to learn that their Social Security benefits may be subject to federal income tax. The taxability of your benefits depends on your combined income, which includes your adjusted gross income (AGI), nontaxable interest, and half of your Social Security benefits.
If your combined income exceeds certain thresholds—$25,000 for single filers and $32,000 for married couples filing jointly—up to 85% of your Social Security benefits may be taxable. To minimize the tax burden, consider strategies such as withdrawing from Roth IRAs, which are not included in the combined income calculation, or managing your withdrawals from other retirement accounts to stay below the taxable thresholds.
Mistake #3: Failing to Plan for Medicare Surtaxes
Medicare surtaxes, also known as the Income-Related Monthly Adjustment Amount (IRMAA), are additional premiums that higher-income retirees must pay for Medicare Part B and Part D. These surtaxes are based on your modified adjusted gross income (MAGI) from two years prior.
If your income exceeds $97,000 for single filers or $194,000 for married couples filing jointly in 2024, you’ll be subject to these additional premiums. To avoid or minimize IRMAA, consider strategies such as reducing taxable income through Roth conversions, charitable contributions, or strategically timing your income.
Mistake #4: Overlooking Roth Conversion Opportunities
Roth IRAs offer significant tax advantages in retirement, as qualified withdrawals are tax-free, and Roth IRAs are not subject to RMDs. However, many retirees overlook the opportunity to convert traditional IRA or 401(k) funds to a Roth IRA, which can reduce future tax liabilities.
Roth conversions are particularly beneficial in years when your income is lower, as you’ll pay taxes on the converted amount at a potentially lower rate. Additionally, converting to a Roth IRA can help you manage your tax bracket in retirement and reduce the impact of RMDs on your taxable income. It’s important to carefully plan Roth conversions to avoid pushing yourself into a higher tax bracket, so consider consulting with a financial advisor to determine the best timing and strategy.
Mistake #5: Neglecting State Taxes in Retirement Planning
While federal taxes often receive the most attention, state taxes can also significantly impact your retirement income. State tax laws vary widely, with some states having no income tax and others taxing retirement income at the same rate as regular income. Additionally, some states offer tax breaks on Social Security benefits or pension income, while others do not.
If you’re considering relocating in retirement, it’s essential to research the tax implications of different states. Even if you plan to stay in your current state, understanding its tax treatment of retirement income can help you plan more effectively. For example, if your state fully taxes retirement income, you might prioritize Roth contributions or other tax-efficient strategies to minimize your state tax burden.
Conclusion
Avoiding these common tax mistakes can help you preserve more of your retirement savings and enjoy greater financial security. By understanding RMDs, managing the tax impact of Social Security benefits, planning for Medicare surtaxes, considering Roth conversions, and accounting for state taxes, you can optimize your retirement tax strategy and reduce the risk of costly errors.
Take proactive steps today to protect your retirement income from unnecessary taxes. Schedule a consultation with one of our financial advisors to review your tax strategy, or download our free guide on retirement tax planning for more tips and insights.