Planning For Gifts And Bequests
As you look ahead, you may be thinking about giving some of your assets to family members or friends, which is often beneficial to both you and them as long as you can afford to live comfortably on your remaining retirement income.
Transferring wealth is often a good way to avoid incurring estate taxesand that’s in turn good because these taxes can take a larger bite of your assets than even the highest income tax rate. In addition, some states impose inheritance taxes at various rates on what your heirs receive from your estate.
But the good news is that prior to your death, you can make gifts to whomever you wishand you can do so up to a certain amount without paying taxes. The IRS ceiling for individuals and married taxpayers changes from time to time.
In addition, you can make larger gifts tax-free to your beneficiaries over the course of your lifetime. You have to follow IRS rules carefully to comply with the lifetime exclusion provisions. For more details, read the instructions for IRS Form 709.
There are pros and cons to making tax-free gifts. On the upside, giving the money away reduces your taxable estatethat is, what will be subject to estate taxes when you diewhile also helping your beneficiaries. But on the downside, once the gift is given, if you need access to that money later in your retirement, it’s gone.
How Does This Strategy Work
Instead of drawing income from investments that are fully or partially taxed during retirement, your clients can help keep their tax bracket down by integrating distributions from cash value life insurance into the mix. By purchasing life insurance, your clients can protect their families and potentially build policy cash values. At retirement, they can take tax-free loans or withdrawals from the cash value to supplement their retirement income, thus helping to minimize their taxes.
Social Security Taxes And The 5 Ways To Bypass Or Lower Them
Social Security income might seem like your just reward for a lifetime of contributing to the program through payroll taxes, but that doesnt mean Uncle Sam wont get his cut once you retire and start collecting benefits.
Depending on your combined income in retirement, you might have to pay federal taxes on Social Security benefits. In this case, combined income is the total of your adjusted gross income , nontaxable interest and one-half of your Social Security benefits, as GOBankingRates recently reported. Heres how it applies to federal taxes:
- If you file a federal tax return as an individual and your combined annual income is between $25,000 and $34,000, you might have to pay income tax on up to 50% of your benefits. If your income is more than $34,000, up to 85% of your benefits might be taxable.
- If you file a joint return and you and your spouse have a combined income of between $32,000 and $44,000, you might have to pay income tax on up to 50% of your benefits. If you earn more than $44,000, up to 85% of your benefits may be taxable.
In addition, 12 states tax Social Security benefits, according to AARP: Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, Rhode Island, Utah, Vermont and West Virginia.
If you want to lower or eliminate federal taxes on your Social Security income, there are a few ways to do so. Heres a look at five of them.
Limit Income From Pretax Retirement Plans
If you have funds in a pretax plan, such as a 401 or funds in an employer-funded pension, withdrawals you make from these plans after you retire are generally subject to income tax. You can usually have the plan administrator deduct taxes from your distributions but, depending on your tax bracket, it may not be enough to cover your bill.
Ultimately, your tax rate is based on all your taxable income during the year. If you have multiple sources of retirement income, you’ll save on your taxes in retirement if you limit distributions from pretax plans to only the amounts you need or are required to withdraw.
Transfer Or Rollover Options
You may be able to defer tax on all or part of a lump-sum distribution by requesting the payer to directly roll over the taxable portion into an individual retirement arrangement or to an eligible retirement plan. You may also be able to defer tax on a distribution paid to you by rolling over the taxable amount to an IRA within 60 days after receipt of the distribution. If you do a rollover, the regular IRA distribution rules will apply to any later distributions, and you can’t use the special tax treatment rules for lump-sums . For more information on rollovers, refer to Topic No. 413 and visit Do I Need to Report the Transfer or Rollover of an IRA or Retirement Plan on My Tax Return?
How Are 401 Distributions Taxed
Distributions from your 401 are taxed as ordinary income, based on your yearly income. That income includes distributions from retirement accounts and pensions and any other earnings. As a result, when you take a 401 distribution, it is important to be aware of your tax bracket and how the distribution might impact that bracket. Any 401 distribution you take will increase your yearly earnings and could push you into a higher tax bracket if you’re not careful.
There is a mandatory withholding of 20% of a 401 withdrawal to cover federal income tax, whether you will ultimately owe 20% of your income or not. Rolling over the portion of your 401 that you would like to withdraw into an IRA is a way to access the funds without being subject to that 20% mandatory withdrawal. Tax-loss selling on poorly-performing investments is another way to counter the risk of being pushed into a higher tax bracket.
Deferring taking Social Security is another way of reducing your tax burden when you take a 401 withdrawal. Social Security benefits are not usually taxable unless the recipient’s overall annual income exceeds a set amount. Sometimes a large 401 withdrawal is enough to push the recipient’s income over that limit.
Here’s a look at these and other methods of reducing the taxes you need to pay when you withdraw funds from your 401
Avoid These Qcd Mistakes
One of the biggest issues with QCDs is the transfers aren’t separated on Form 1099-R, which reports retirement plan distributions to the IRS.
For example, if you withdraw $50,000 in a year and $20,000 is for a QCD, the form will still report $50,000 in total distributions, even though only $30,000 is taxable income, Foster said.
“It’s up to you to keep track of how much of that money went directly to charity,” he said.
Additionally, the payment from the IRA must be made out to the charity. If you write a check from your IRA to a charity at the end of December, it must clear from your IRA by Dec. 31 to count for the year, May said.
Retirees, however, may bypass the issue by having their custodian cut the check.
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If Your Life Expectancy Is Less Than A Year
You may be able to take all the money in your pension as a tax-free lump sum, if all of the following apply:
- youre expected to live less than a year because of serious illness
- you dont have more than the lifetime allowance of £1,073,100 in pension savings
If youre over 75 youll pay Income Tax on the lump sum.
Check with your pension provider. Some pension funds will keep at least 50% of your pension for your spouse or civil partner.
Contribute To Or Convert To Roth Accounts
If you havent finished working yet, consider whether you should be contributing to a pretax retirement account like a traditional IRA or 401 or an after-tax retirement account like a Roth IRA or 401. If you expect to have more taxable income once you retire whether thats from dividends, Social Security payments or selling investments you can reduce your taxes by contributing to a Roth account so the distributions wont be taxed.
Or, if you expect that income tax rates will increase in future years, convert a portion of your retirement savings to a Roth IRA. Youll pay taxes in the year of the conversion, but the later withdrawals from the Roth account will be tax-free.
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Traditional Approach: Withdrawals From One Account At A Time
To help get a clearer picture of how this could work, let’s take a look at a hypothetical example: Joe is 62 and single. He has $200,000 in taxable accounts, $250,000 in traditional 401 accounts and IRAs, and $50,000 in a Roth IRA. He receives $25,000 per year in Social Security and has a total after-tax income need of $60,000 per year. Let’s assume a 5% annual return.
If Joe takes a traditional approach, withdrawing from one account at a time, starting with taxable, then traditional and finally Roth, his savings will last slightly more than 22 years and he will pay an estimated $66,000 in taxes throughout his retirement.
Withdrawing from one account at a time can produce a “tax bump” midway in retirement
Note that with the traditional approach, Joe hits an abrupt “tax bump” in year 8 where he pays over $5,000 in taxes for 11 years while paying nothing for the first 7 years and nothing when he starts to withdraw from his Roth account.
In this scenario, a proportional withdrawal strategy in retirement can cut taxes
Taxes On Investment Income
As a retiree, you may also have income coming in from investments in a taxable account. If that’s the case, it’s important to understand the rules that apply:
- Interest income is usually taxed at your ordinary tax rate. That includes income from certificates of deposit , most bond interest, and interest from checking or savings accounts.
- Income from selling an investment for more than you paid for it is usually taxed at either the long-term capital gains tax rate . If you sell it within a year, you’ll be taxed at the short-term capital gains rate, which is your ordinary income tax rate.
- Dividend income is typically taxed at preferential rates provided certain criteria are met, including being paid the dividend by a U.S. corporation or qualified foreign corporation and not falling into excluded categories. You also must have held the stock that pays the dividend for a certain minimum period. If your dividend isn’t considered “qualified,” it’s taxed at your ordinary income tax rate.
Understanding these tax rules is important when you select investments so you can make an accurate assessment of the amount of after-tax income they will provide during your retirement.
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Consider Relocating To A State That Doesnt Tax Benefits
Federal taxes are only one side of the equation, and you could face state taxes on your benefits as well. The majority of states do not tax Social Security benefits, so theres a good chance youre already off the hook. However, a handful of states still tax benefits to some degree.
Utah and Nebraska follow the federal tax guidelines, using your combined income to determine how much youll pay in taxes. Montana, New Mexico and West Virginia also tax benefits, but they have certain modifications. For example, in West Virginia, state taxes on benefits are being phased out, so retirees can expect to pay less in taxes each year until 2022, when benefits will be exempt from taxes.
Many other states exclude Social Security benefits from taxation based on factors like age or income level, so you might be able to get out of paying taxes depending on how much youre withdrawing from your retirement accounts.
Keep in mind, though, that Social Security taxes are only one factor to consider if youre thinking about moving. Some states might not tax benefits but have exorbitant property taxes, for instance. Or you could get a tax break but reside in a state where the general cost of living is far higher than average. So before you start packing your bags, make sure youve considered the big picture.
Doing No Tax Planning Before Retirement
Tax planning does you no good after the year is over. Low-income years can be particularly useful, and you can use them to your advantage. Losing a job or otherwise having less income for some reason is never good, but it might present a tax-planning opportunity.
You might be able to convert some of your IRA to a Roth IRA and pay little to no tax if you’re experiencing a year where you have low income and high tax deductions, such as mortgage interest or health-related expenses. This can save you thousands of dollars, but it doesnt happen unless you do your tax planning before the year ends.
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What Pitfalls Could Affect My Retirement Savings
When planning for retirement, its important to remember that higher tax bills and surcharges for retirees can become an unwelcome part of retirement if theyre not careful. From increased taxes on Social Security, Required Minimum Distributions , and higher Medicare premiums, these pitfalls can prove to be a problem if you are not prepared. The three most common tax pitfalls upcoming retirees should look out for are:
Not Strategically Choosing How And When To Withdraw Income
One of the biggest tax mistakes retirees make is taking Social Security early while waiting to withdraw from IRAs and other retirement accounts until they’re required to do so.
Using your retirement money in the wrong order can mean paying thousands more in taxes each year than you would have had to pay if you’d rearranged things based on a strategy that would get you the most after-tax income.
This is especially true if you have no pension and most of your retirement income will come from Social Security and IRA money. An experienced retirement planner can help with this kind of planning, and it can result in more after-tax retirement income for you.
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Brilliant Ways To Reduce Your Taxes In Retirement
10 Brilliant Ways To Reduce Your Taxes in Retirement
Though taxes might not be the first thing you think of when it comes to how you want to spend money in retirement, planning strategically can mean more funds for the things you love. Thats why when youre budgeting for retirement, its important to factor in how much of your money will be going to the IRS each year.
Reducing your taxes after retirement can help you reduce the savings you need to retire in your state. See how you can maximize your retirement savings.
Tax Diversification In Action
So, what’s the right mix of retirement accounts for you? “That depends on several factors, including your current marginal tax rate, your tax rate in retirement, and how much flexibility you’d like when making withdrawals in retirement,” says Hayden Adams, CPA, CFP®, and director of tax planning at the Schwab Center for Financial Research. Nevertheless, there are some basic guidelines you can consider when deciding which retirement accounts to fund first:
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Ways To Withdraw Money In Retirement
It’s official: You’re retired. That probably means no more regular paycheck, and you may need to turn to your investments for income. But remember: The impact of taxes is just as important to consider now as it was when saving for retirement.
The good news is that in retirement there may be more options to increase after-tax income, especially when savings span multiple account types, such as traditional retirement accounts, Roth accounts, and taxable savings like brokerage or savings accounts. The not-so-good news is that choosing which accounts to draw from and when can be a complicated decision.
“Many people are seeking ways to help reduce the taxes that they will pay over the course of their retirement,” says Andrey Lyalko, vice president of Fidelity financial solutions. “Timing is critical. So, how and when you choose to withdraw from various accounts401s, Roth accounts, and other accountscan impact your taxes in different ways.”
Taxes matter: How different accounts are taxed
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How Taxes Factor Into Your Retirement Plan
You might already face taxes on your retirement account withdrawals, and Uncle Sam could take a bite out of your Social Security benefits as well. But if youre strategic about how you save for retirement as well as what state you call home in your senior years, you just might be able to avoid taxes entirely and keep more of your hard-earned money.
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