Retirement Tax Planning: Avoiding Common Tax Hits in Retirement
3 Tax Hits Retirees Need to Watch Out For
The IRS may come after your money in retirement. Here's what you can do about it. It's hard to get out of paying taxes in general. But many people assume that once they start retirement, they'll be able to magically avoid owing the IRS money.
Unfortunately, that line of thinking could lead to a world of financial upheaval for you. That's because many common forms of retirement income are indeed subject to taxes. Here are three specific tax hits you might incur -- and what to do about them.
Taxes on bond interest
Retirees are often advised to load up on bonds because they tend to be more stable than stocks while offering steady interest income. To be clear, this doesn't mean that as a retiree, you should unload your stocks completely. But you may decide to maintain a fairly even mix of stocks and bonds as a senior.
You should know, however, that bond interest is generally considered taxable. So if you have a bond portfolio, you may need to prepare to lose a portion of your interest income to the IRS.
However, you can avoid that tax hit by loading up on municipal bonds, which are bonds issues by cities, states, and other localities. When you own municipal bonds, your interest payments are always tax-free at the federal level. And you can avoid state and local taxes on that interest by purchasing bonds issued by your state of residence.
Taxes on RMDs
If you have money in a traditional IRA or 401(k) plan, you'll have to start thinking about required minimum distributions, or RMDs, once you turn 73 (though that age was recently moved back to 75 for those born in 1960 or later). RMDs are calculated based on your account balance and life expectancy each year. And failing to take them could result in costly penalties.
But because RMDs count as IRA or 401(k) withdrawals, they're subject to taxes. So if you want to avoid RMD taxes, you'll need to try to avoid RMDs, period. And you can do that by housing your retirement nest egg in a Roth IRA or 401(k).
It used to be that Roth 401(k) plans forced savers to take RMDs. But changes to the rules now allow you to leave your Roth 401(k) untouched for as long as you want to. And if you currently have your savings in a traditional retirement plan, you can convert it to a Roth ahead of retirement to get out of RMDs later on.
Taxes on Social Security
Very low earners may not have to pay taxes on their Social Security benefits. But if you have even a small amount of retirement income at your disposal outside of those monthly benefits, then taxes on Social Security income may apply to you.
Whether you'll be taxed on your Social Security depends on your provisional or combined income. And that's calculated as 50% of what Social Security pays you per year plus your adjusted gross income and tax-free interest income, like municipal bond interest. If your provisional or combined income exceeds $25,000 as a single tax-filer or $32,000 as a married couple filing jointly, taxes on your Social Security benefits start to apply.
One thing you may be able to do to avoid those taxes, though, is to keep your retirement savings in a Roth IRA or 401(k). Withdrawals from one of these plans won't count toward your provisional or combined income, thereby lessening your chances of having your Social Security benefits taxed.
It's not at all a given that you won't pay the IRS a lot of money in retirement. Depending on your situation, you could end up with a pretty sizable tax burden. But now that you're aware of the various income sources that may be taxable in retirement, you can take steps to work around those rules and minimize your personal tax hit.