Retirement is supposed to be a time for relaxation. Solid financial planning and preparation – especially relative to taxes – can help ensure it is. The following are six steps you can take before and during retirement to minimize your tax burden.
1. Consider Roth Conversions
If you anticipate having a low-income year, either before or during retirement, consider a Roth conversion, which is essentially “moving” money from your traditional IRA to your Roth IRA. The distribution from the traditional IRA is taxable at the time of the conversion, but at a tax rate that is much lower than normal and, best of all, the money will grow tax free from that point on.
2. Continue Contributing to Your IRA
For people who keep working after their “first” retirement, ongoing contributions to retirement funds can increase the amount of tax-deferred (with a traditional or self-employed IRA) or tax-free (Roth) savings for the future. While traditional IRAs do not allow contributions past 70½ years old, SEP and Roth IRAs have no age limit. If you have extra income, putting more money in these vehicles while you are still working will lessen the financial burden of later years when working even part-time might not be an option.
3. Don’t Forget to Deduct Medical Expenses
Retirees can take a host of medical deductions to minimize their tax obligations. Among the un-reimbursed medical expenses to itemize: insurance premiums, prescription drugs and nursing home care. If you are 65 years of age or older, medical costs can be deducted up to 7.5% of your adjusted gross income (AGI), an important tax income number upon which many deductions are based. If you are younger than 65, you can deduct up to 10% of your AGI. In both cases, your total itemized deductions should exceed your standard deduction.
4. Make Charitable Donations from your IRA
Donations from your IRA of up to 50% of your AGI are tax deductible. Charitable gifts from your IRA also count toward your required minimum distribution. These distributions are normally taxed, but they are tax-free if taken as a charitable donation. And because the income is not included in your AGI, it may actually increase the size of other deductions that are based on AGI within your tax return.
5. Evaluate the Need for Quarterly Tax Payments
If you’re like most people, your employer withheld taxes from your paycheck during your career. However, many retirees no longer receive a paycheck and thus have no tax withholding. Individuals with no withholding are required to make quarterly tax payments to the IRS throughout the year as income is earned. If you wait until April 15 (instead of making estimated quarterly payments), you could be in for extra penalties and fees. Therefore, it’s a good idea to pay careful attention to what you owe. Keep an eye on your deductions and earnings to make sure that you are paying the correct amount at the correct time.
6. Control – or Reduce – Your Spending
No matter how many tax deductions you can take advantage of, your spending is one variable that you can control and which may lessen your tax burden. Budgeting can be very helpful, given that many retirees find themselves spending more during retirement.
If your primary income source is your traditional IRA, lower spending means you withdraw less from your account and, thus, reduce your tax bill. Across the board, the less you spend, the more you have in store to cover any unseen expenses down the line. There are other benefits to lower spending: consider how retirement success may be correlated with “regulated” spending. Pre-retirees will also want to ensure that investing expenses don’t eat into their retirement nest eggs.
While tax planning may not be the first thing you associate with a relaxing retirement, a little forethought goes a long way to help ensure that you can afford to live the lifestyle you want for your golden years.