Navigating Taxes in Retirement

The tax landscape shifts suddenly when most Americans leave the labor force to retire.  The single most important thing to remember is that income taxes can fall dramatically, because retirement incomes are typically lower and because all or a portion of your Social Security benefits will be tax-exempt.

This was among the tax insights supplied by Vorris J. Blankenship, a retirement tax planner near Sacramento, California, who has just finished the 2015 edition of his 5-inch thick “Tax Planning for Retirees.”   The following is an edited version of tax information he supplied to Squared Away:

Lower taxes in retirement. Brian and Janet are a hypothetical couple renting an apartment in Nevada, a state with no income tax. In 2013, Brian earned $40,000 at his job, and Janet’s wages were $20,000, for a total income of $60,000. They took the standard deduction on their federal tax return and paid income tax of $5,111.

Brian retired on December 31, 2013. In 2014, he received Social Security payments of $15,000 – $2,750 of which was taxable – and a fully taxable pension from his former employer of $10,000. About one-third of retirees pay some income taxes on their Social Security benefits, because their retirement income exceeds certain thresholds in the tax code.

In 2014, Janet again earned $20,000, but the couple’s total household income declined to $45,000 from $60,000. They took the standard deduction on their federal tax return and paid income tax of only $1,248.

The 75 percent reduction in their taxes is much larger than the 25 percent decline in their income after Brian retired.

Control your 401(k) or IRA withdrawals. Some retirees take a lump sum distribution of all the funds in their IRA or 401(k). Doing so pushes their taxable income temporarily into a much higher tax bracket, sacrificing financial assets they may need as they age. A slow, judicious withdrawal of funds over many years in retirement not only prevents a large, one-time tax hit. It also preserves retirement savings while allowing investment income to continue accumulating tax-free, both of which provide more long-term financial security.

Assume our hypothetical retiree, Brian, had $150,000 in a 401(k) that he unwisely liquidated when he left his employer. He made no additional contributions to the plan so the entire $150,000 withdrawal is taxable. Brian and Janet’s total income for 2014 – Brian’s first year in retirement – balloons from $45,000 to $195,000, pushing them into a much higher income tax bracket with a 28 percent top marginal tax rate, compared with 10 percent if he had not liquidated the 401(k).

The widow(er)’s tax break. Federal tax law requires individuals who reach age 70½ to begin taking required minimum distributions (RMDs) from their 401(k)s or IRAs, triggering tax payments on the amount withdrawn. In the initial years, the RMDs are a small percentage of a retiree’s total retirement savings balance, but this percentage increases with age.

When the retiree with the tax-exempt plan dies, the spouse who inherits the balance in those accounts can roll them over to an IRA in her own name.   Surviving spouses are often younger, which means they can avoid the RMD altogether – if they’re still under 70 ½.  If they’re over 70 ½, they will face a lower RMD percentage on the inherited assets, because they’re younger than their former spouse.  In either case, the tax bite will be smaller, if the assets were rolled over to the survivor’s new plan.

The Roth IRA advantage. It may make sense for some well-heeled retirees to roll over some funds from a traditional IRA to a Roth IRA.  The primary advantage of a Roth IRA is the ability to pay for nursing home or other large expenditures down the road without incurring the high marginal tax rates that withdrawing large amounts from a traditional IRA would trigger. In a Roth IRA, a retiree can withdraw money, including the investment income, totally tax-free if he has had the Roth IRA for more than five years.

Since the funds being withdrawn from a traditional retirement account are taxable, a gradual rollover will minimize the taxes paid each year. Timing is also critical.  The lower tax rate that often comes immediately after retiring may provide the best opportunity to fund a Roth IRA – before the RMDs have started.  Under tax law, any taxes triggered by a rollover would be in addition to the RMD taxes.