As if planning for retirement wasn’t already a tricky venture, a complex tax code can make things even more difficult, which is where a comprehensive retirement tax strategy can come in handy.
Unfortunately, it is common for many people to pop the champagne and prepare for retirement only to discover that their nest egg was not materially as big as they once thought it was. Rather than simply focusing your retirement plan on how much you have saved—something still worth actively thinking about—it will also be important to design a retirement plan that considers the logisticsinvolved in accessing your savings. Things such as taxes, penalties, and liquidity issues should all actively be addressed.
In this article, we will discuss four hidden retirement taxes that tend to surprise aspiring retirees. We will also discuss how to avoid (or minimize) these taxes and how to better prepare yourself for the future. By taking the time to develop a robust, tax-efficient retirement plan, you can maximize your savings and prepare yourself to retire on time.
1) Hidden Retirement Tax: Social Security Benefits
When people think about how their retirement savings will be taxed, they typically think about federal taxes first. After all, Social Security is a federal savings program, and other retirement accounts—such as a traditional IRA, Roth IRA, and 401(k)—are all governed by federal laws and regulations. But what many people fail to realize is that their Social Security income could be affected by the states they live in, too.
Currently, a total of 13 states tax Social Security benefits. These states include Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, and West Virginia. Some cities and counties levy additional taxes, as well. While these benefits might not be taxed the same as ordinary income, these taxes can indeed cause people to lose a notable chunk of their savings.
These state taxes are levied in addition to federal taxes on Social Security, which can be applied to up to 85% of your benefits.
How to Avoid State Taxes on Social Security Benefits
Establishing residency in a different state can help you avoid some or all of these taxes. Currently, seven states (AK, FL, NV, SD, TX, WA, and WY) do not tax any form of income, at all. If you are considering moving, be sure to speak to a financial planner in the state that you are moving to. You should also holistically plan for retirement and factor in the cost of living—for example, while Washington does not tax income and Missouri does tax retirement income, choosing to retire in St. Louis will still be much more affordable than choosing to retire in Seattle.
In many cases, retirees find they are better off staying put, and simply account for any state taxes in their retirement tax strategy.
2) Hidden Retirement Tax: Required Minimum Distributions (RMDs)
Once you’ve reached the age of 72, you will be required—by law—to begin making minimum withdrawals from (most) your retirement accounts. In most cases, these withdrawals will be taxed and treated as ordinary income, both at the state and the federal level. Depending on how much you’ve actually managed to save, these minimum distributions can push you into a higher tax bracket (especially if you are still actively working).
If you neglect your RMDs or miscalculate them, then you could be looking at a 50% tax levied on the difference between what you were required to withdraw and what you actually withdrew.
How to Avoid Minimum Distribution Fallout
Roth IRAs are different from traditional retirement plans in the sense that they are taxed “on the way in”, rather than “on the way out.” Roth IRAs are ideal for individuals who anticipate having higher incomes in the future than they do in the present. To avoid being pushed into a higher tax bracket because of minimum distributions, consider investing in a Roth IRA early on or converting your retirement account into a Roth IRA before you reach the age of mandatory withdrawals.
To make sure you aren’t hit with the 50% penalty tax, consider working with a financial professional to calculate and execute RMDs as part of comprehensive tax planning.
3) Hidden Retirement Tax: Estate
Although Congress raised the floor for levying estate taxes to $11,180,000, a handful of states levy additional taxes. The threshold for state taxes is much lower, though, ranging from $2.1 to $5.6 million.
Currently, the 12 states imposing an estate tax (in addition to the federal estate tax) are Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, and Washington. The District of Columbia also issues an estate tax.
How to Avoid Estate Taxes
As we saw with social security taxes, being subject to estate taxes will depend on where you choose to live. Establishing legal residency in multiple states can help you avoid certain estate taxes, though this can also create additional complications. Restructuring an estate to include unique, non-taxable assets (such as investing it in a business or packaging an estate into a trust) may also help you avoid these taxes.
Since estate tax law can often be rather complicated, be sure to speak with an advisor that is registered in your current state.
4) Hidden Retirement Tax: Capital Gains
Capital gains are profits generated through sale of an appreciated asset. Qualifying assets can be anything from physical property, like a house or antique, to stocks and bonds.
Because there are many ways to create capital gains, we’ll focus on one example: Many people choose to sell their home upon retirement, whether to simply downsize or to access the equity they’ve built as homeowners over the years. However, as you may have discovered in the past, the amount you are able to sell your home for will not always be what you are able to receive. In addition to closing costs, selling costs, and other expenses connected to selling your home, you might be subject to federal capital gains taxes, as well.
How to Avoid Capital Gains Taxes
When an individual earns more than $250,000 (or a couple earns more than $500,000) from selling their home, they will need to pay capital gains taxes. However, by deducting the expenses that come with selling your home, you might be able to lower your gains and, thus, lower the federal taxes being levied against you. Choosing to forego depreciation deductions over the course of owning your home can also help you avoid the depreciation recapture tax that applies to some home sellers. Timing your cash flows and accounting for every financial component of buying and selling your home can potentially help you lower the amount you owe the government.
This process and similar workarounds can be applied to capital gains generated by other assets. Working with a financial professional will help you account for every opportunity to lower your taxes in retirement.
Taxes in retirement are inevitable, just as they are during professional years. However, with some careful planning and financial savvy, many taxes in retirement can be avoided or reduced.
Whether you are one year or 20 years away from your retirement, consider meeting with a financial planner. These qualified individuals will help you coordinate the logistics of your retirement, identify the true value of your nest egg, and help you avoid paying more taxes than is legally necessary.
The financial advisors at Advanced Retirement Strategies have decades of combined experience helping clients transition into retirement. Using sound investment strategies, extensive social security knowledge, and calculated tax strategies, Advanced Retirement Strategies provides resources and services to residents of Bountiful, Utah and the surrounding area who are eager to make the most of their retirement years.
If you are within ten years of retirement and have over $250k in assets, click here for a free retirement review from Advanced Retirement Strategies to gauge the efficiency of your investments, income plan, and tax strategies.