Tax Planning Strategies for Retirees

Retirees Have Options for Tax Planning

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Planning ahead can go a long way toward keeping your taxes as manageable as possible when you reach your retirement years. Retirees have some control over their tax situations, because they can decide how much they want or need to withdraw from their various retirement plans. They can take advantage of other special tax breaks as well.

Standard vs. Itemized Deductions

You'll want to take full advantage of standard or itemized deductions, because these determine how much of your income will escape taxation. Your taxable income is what's left after you take these deductions, and your taxable income determines your tax bracket and tax rate.

Retirees can coordinate their taxable retirement distributions with several itemized deductions:

  • Interest paid on loans of up to $1 million if the mortgage was taken out before December 15, 2017, or $750,000 if it was taken out after that date
  • Real estate taxes up to $10,000 in most cases
  • Medical expenses over 7.5% of your adjusted gross income (AGI) as of tax year 2020

But claiming the standard deduction can well turn out to be the better deal for retirees, because it increases for taxpayers who are age 65 or older as of the last day of the tax year. You'll get an additional $1,300 for each spouse, or $1,650 if you're not married, as of tax year 2020.

You can't both itemize and claim the standard deduction for your filing status—it's an either/or decision—and the standard deductions are pretty significant as of tax year 2020, thanks to the Tax Cuts and Jobs Act (TCJA).

Tax pros recommend that you run the numbers both ways, adding up all of your itemized deductions and then comparing that total to your standard deduction. Determine which amounts to more.

Accelerate Retirement Plan Contributions

Consider accelerating your retirement plan distributions if you have a lot of available deductions this year. You might withdraw more retirement funds than you need in a year when your deductions exceed your taxable income, or whittle it down into a very low tax bracket.

You could avoid paying more taxes in a future year if you take more sizable withdrawals now, when you have a zero or a low tax rate.

Or Defer Retirement Plan Distributions 

The flip side of this strategy is to defer your retirement plan distributions until you really need them, or they become required by law. Keeping your taxable distributions to a minimum will push more of your income to future tax years if you expect that you'll fall into a lower tax bracket at that time, as compared to the tax bracket you're in for the current year. 

Taxpayers must begin withdrawing funds from their 401(k)s and traditional IRA plans at age 72, or age 70 1/2 if they reach this age by January 1, 2020. These required minimum distributions (RMDs) must start by April 1 of the year following the year in which they reach that birthday. This is called the "required beginning date."

The minimum amount that must be distributed is your account balance divided by the life expectancy figures published by the IRS in Publication 590. You can use web-based calculators to estimate your required minimum distributions. Plan to withdraw at least the minimum amount required from your traditional IRA and 401(k) accounts.

Roth IRAs and designated Roth 401(k) accounts are exempt from required minimum distribution rules. 

The Tax Credit for the Elderly 

The Tax Credit for the Elderly is a special tax credit that can be claimed by taxpayers who are age 65 or older, but qualifying for it requires careful retirement tax planning—your AGI must fall beneath certain limits as of tax year 2020:

  • $17,500 if you're single, head of household, or a qualifying widow(er)
  • $20,000 if you're married, file a joint return, and just one spouse qualifies
  • $25,000 if you're married, file a joint return, and both spouses qualify
  • $12,500 if you're married, file a separate return, and you lived apart from your spouse throughout the entire tax year

You're also disqualified if the combined total of certain nontaxable retirement benefits exceeds certain thresholds. These include nontaxable Social Security benefits, as well as nontaxable pension, annuity, or disability income. The limits as of the 2020 tax year are:

  • $5,000 if you're single, head of household, or a qualifying widow(er)
  • $5,000 if you're married, filing a joint return, and just one spouse qualifies
  • $7,500 if you're married, filing a joint return, and both spouses qualify
  • $3,750 if you're married, file a separate return, and you lived apart from your spouse throughout the entire tax year

You can't claim the credit if your AGI or your sources of nontaxable retirement income top these limits.

This credit ranges from $3,750 to $7,500 as of tax year 2020, depending on your income and other factors.

Maximize Your Tax-Free Income

Taxpayers can exclude up to $250,000 from capital gains tax when they sell their main home. This figure doubles to $500,000 for married couples.

Interest earned from municipal bonds is also exempt from federal taxes.

Retirees often receive income from a variety of sources, including Social Security benefits and distributions from pensions, annuities, IRAs, and other retirement plans. Each is subject to slightly different tax rules.

Social Security Income

Your Social Security benefits might be completely or partially tax-free, depending on your overall income from all sources.

Your benefits generally will only be taxable if you have other income, such as from working or retirement plans. At most, you'll pay tax on 85% of your Social Security benefits if your income from all other sources plus half of your Social Security benefits is more than $34,000 as of tax year 2020, and you're single. This increases to $44,000 if you're married and file a joint return.

Unfortunately, you'll most likely pay taxes on all of your Social Security benefits if you're married but filing a separate tax return.

Only 50% of your benefits will be taxed if your overall income is less than $34,000 or $44,000, respectively, and they might not be taxable at all if you don't have much else in the way of income: less than $25,000 in tax year 2020 if you're single, or $32,000 if you're married and filing jointly.

Pension or Annuity Income 

Your pension or annuity income might be either fully or partially taxable.

Your distributions will be fully taxable if all contributions to your pension were made with tax-deferred dollars, but you can exclude from taxable income any portion of your distributions that's representative of recovery of your cost in the plan—in other words, you made contributions with money that had already been taxed. Part of your distributions would be considered a recovery of that cost basis. Only the remainder will be taxable income.

Consult with a tax professional if you made any tax-deferred contributions, because this calculation can get complicated.

Your plan administrator can calculate the taxable portion of your pension distribution for you. Contact the administrator to find out what your pension payments will be and what part of those payments will be considered taxable.

IRA Distributions 

Distributions from your individual retirement account might also be fully taxable, partially taxable, or completely tax-free. It depends on what type of IRA you have. 

Your distributions will be fully taxable if you have a traditional IRA and made tax-deductible contributions. You contributed funds using pre-tax dollars, and tax is deferred on both the contributions and the earnings until they're withdrawn.

Your distributions will be partially taxable if you have any basis in a non-deductible traditional IRA. A portion of your distribution represents a return of your non-deductible investment and that portion is recovered tax-free.

Distributions from Roth IRAs are completely tax-free as long as you meet two basic requirements: Your first Roth IRA contribution was made at least five years prior to any distribution, and the funds are distributed after you reach age 59 1/2.

401(k) Plans 

Distributions from your employer's 401(k) plan are fully taxable, because the contributions were excluded from your taxable income at the time they were made. Distributions from Roth 401(k) accounts are treated the same as Roth IRA distributions.