Everyone’s dream is an easy retirement free of financial woes. However, proper planning during working years is essential for ensuring a smooth and relaxing future. Understanding how retirees pay their taxes is a key part of financial planning that can help those planning ahead avoid paying high taxes and depleting their retirement funds.

Federal tax attorneys from Delia Law share key tax considerations and strategies for current and future retirees to optimize their retirement finances.

Key Tax Considerations For Retirees

Required Minimum Distributions (RMDs) From Retirement Accounts

RMDs are the mandatory amounts that retirees must withdraw from their retirement savings accounts annually, starting at age 73 or 72 if you reached that age before December 31, 2022, when the SECURE 2.0 Act came into effect. This rule ensures that savings accumulated in tax-advantaged accounts like traditional IRAs and 401(k) plans are eventually subject to taxation.

Failing to comply with RMD rules can result in a tax penalty of 50% of the RMD not taken. For retirees, careful planning is required to meet withdrawal requirements without significantly impacting their account balance and strategically manage their tax liabilities each year.

Social Security Benefit Taxation

About 40% of Social Security recipients must pay federal taxes on their benefits if their total income exceeds certain thresholds (between $25,000 and $34,000, up to 50% of income is taxable, and over $34,000, up to 85% is taxable). The portion of benefits taxed depends on the person’s “combined income,” including their adjusted gross income, nontaxable interest, and half of the Social Security benefits.

For retirees, this means they have to manage other income sources to minimize their tax liability on their Social Security benefits. Retirees can opt for federal tax withholding on Social Security benefits to manage expected tax dues more effectively, meaning taxes will be paid throughout the year rather than in one lump sum.

State Tax Implications For Retirees

Each state has its own rules regarding the taxation of retirement income. Seven states, including Florida and Texas, do not tax retirement income at all, while others may offer exemptions or deductions that can provide significant tax relief.

Retirees might consider relocating to states with favorable tax treatments to maximize their retirement income if they can. Choosing a retirement-friendly state can be a strategic decision that significantly improves their financial health.

Capital Gains Tax Planning for Investments

Capital gains tax is levied on the profit made from selling assets like stocks, bonds, and real estate. The rate depends on how long the asset was held—short-term or long-term—with long-term gains generally taxed at lower rates.

For retirees, timing the sale of investments so they qualify for long-term capital gains tax rates can result in substantial tax savings. This usually involves holding assets for over a year before selling them.

Capital losses (when you sell something for less than you bought it) can offset gains and reduce taxable income, providing a cushion against market volatility. Additionally, placing investments in tax-advantaged accounts like IRAs can defer or eliminate capital gains taxes.

Top Tax Tips

Roth IRA Conversions Before Retirement

The Roth IRA conversion ladder is an effective method of accessing retirement funds without penalties. This involves gradually transferring money from a traditional IRA or 401(k) into a Roth IRA. Each conversion has a five-year waiting period before the funds can be withdrawn penalty-free.

By planning consecutive annual conversions, retirees can set up a steady flow of accessible funds. This is particularly advantageous because withdrawals from Roth IRAs are tax-free, provided the account has been open for at least five years, and the owner is over 59½ years old.

Charitable Giving Strategies To Reduce Tax Burden

Charitable giving is not only a noble endeavor but can also be a strategic financial move. Donating to charity can significantly lower taxable income for those who itemize their deductions. One effective method is to donate appreciated stocks or bonds directly to a charity, bypassing capital gains taxes and possibly qualifying for a tax deduction based on the asset’s total market value.

For those over 70½, considering a qualified charitable distribution (QCD) from an IRA can satisfy their required minimum distributions (RMDs) while excluding the amount donated from their taxable income. This can be particularly beneficial for those who do not need to draw from their IRAs for living expenses.

Health Savings Account (HSA) Contributions and Usage

HSAs offer a triple tax advantage—contributions, earnings, and withdrawals for qualified medical expenses are all tax-exempt. For those over 65, HSAs become even more flexible, allowing withdrawals for any purpose without penalties, although non-medical withdrawals are subject to regular income tax. Maximizing contributions to an HSA can be a wise strategy, especially when anticipating future medical expenses or Medicare premiums. By paying current minor medical expenses out-of-pocket and preserving HSA funds, people can build a tax-free nest egg for future health-related costs.

Tax-Loss Harvesting In Taxable Investment Accounts

Tax-loss harvesting is an effective way to reduce taxes on capital gains from investments. Selling underperforming stocks at a loss can offset gains from better-performing assets, thus reducing overall taxable income. If losses exceed gains, up to $3,000 annually can be deducted from taxable income, carrying over any additional loss to future years. This strategy requires careful consideration to avoid the wash-sale rule, which disallows a tax deduction for a loss if a substantially identical asset is purchased within 30 days before or after the sale.

Consideration Of Annuities for Tax-Deferred Growth

An annuity is when, in exchange for a payment, an insurance company agrees to make regular payments to someone, either immediately or at some point in the future. Annuities can be a reliable source of income during retirement, as they offer the potential for a steady income stream and can be tailored to different retirement timelines and financial needs.

When considering annuities, it’s important to understand the fees, surrender charges, and the tax implications of withdrawals to ensure they align with the overall retirement strategy.

Dawn Delia, Federal Tax Attorney at Delia Law, commented:

“Effective tax planning is critical for securing a financially stable retirement. By understanding the various tax considerations and strategies, retirees can optimize their income and minimize their tax liabilities, meaning their retirement can be more comfortable, and they can worry less about running out of funds to support themselves.

“However, the complexity of tax laws and individual financial circumstances makes it important to seek personalized advice. Consulting with a financial advisor or a tax professional can provide tailored guidance aligned with each individual’s specific retirement goals and financial situation. This professional input can be invaluable, helping individuals cut through all the tangled legal jargon and avoid costly mistakes they might otherwise not have seen coming.”

Disclaimer: All information in this article has been prepared for informational purposes only and does not constitute legal advice.

Related Articles

• Money Milestones To Expect in Your 50s, 60s and 70s
• The Importance of Taxes and RMDs on Your Retirement Accounts

Reviewed November 2024

About Delia Law

Delia Law is a firm of experienced IRS tax attorneys with extensive knowledge of federal tax laws. We provide personalized tax resolution options to suit individual tax situations and financial circumstances.