Many retirees assume their highest tax years are behind them. For some, their biggest tax surprise is still ahead.
We help our clients with their tax strategy by reviewing their tax returns annually, looking for opportunities to lower their lifetime tax bill. During these reviews, we often see a trend that catches retirees by surprise - their taxable income actually increases in retirement.
Once working income stops, people expect their total income to be lower in retirement. Sometimes, that’s the case. For others, their retirement years bring higher income than previous working years. The discrepancy between expectation vs. reality can mean a hidden tax trap for retirees.
In today’s post, you’ll learn:
How your retirement years can result in higher income than your working years
The hidden tax trap and its negative impact
How to avoid the tax trap
How Income (and Taxes) Can Be Higher in Retirement
During their working years, most people receive W-2 or 1099 income. It’s predictable and the tax withholding is more manageable since it comes from one source – your wages.
In retirement, however, more income levers are turned on. Your working income is replaced by income from other sources, including:
Retirement portfolio withdrawals
Required Minimum Distributions
Pension and Social Security benefits
Interest from CDs and bond funds
Dividends and realized capital gains
Real estate or business income
Money inherited from family
As income is generated from each of these sources, tax planning becomes crucial. Retirees must estimate how much income is generated from different places and the taxes that come with it. The timing of generating income becomes much more important to your retirement tax planning.
Here’s a real-life example that might resonate with you:
Bob and Mary are a recently retired couple. Bob retired from his job at the State of Hawaii and Mary retired from the federal government. In their final year of full-time work, they earned about $100,000 in total.
Now retired, they both receive a monthly pension in addition to their Social Security benefits. They have saved about $1 million in their IRAs and employer-sponsored retirement plans. Last year Mary’s mother passed away, leaving her about $250,000 in an inherited IRA.
In this example, Bob and Mary have greater income post-retirement than when they were working full-time. Their tax situation is more complicated because their income comes from multiple sources instead of W-2 income.
The Hidden Tax Trap
Having higher income than expected in retirement can result in a hidden tax trap in two ways.
Income from various sources gets stacked on top of each other. Crossing certain income thresholds can result in your Medicare premiums increasing by thousands of dollars per year.
More of your Social Security benefits, for example, become taxable as your income increases. Certain deductions may be lost based on your higher level of income.
Ed Slott calls this the tax torpedo – the unintended tax consequences retirees encounter due to the interaction between taxable income and Social Security taxation.
Retirees may be surprised to find their average tax rate is higher in retirement than when they were working due to the increase in taxes and loss of deductions. This is a problem especially for retirees in their 70s, who receive Social Security benefits and have begun taking Required Minimum Distributions. Unless you’re intentional about smoothing your tax rate across your retirement years, you may find yourself going from low tax years early in retirement to unexpectedly higher tax years later.
Underpayment Penalties
Higher income than expected can also cause retirees to underestimate their tax withholding and estimated tax payments.
Generally, I advise clients that whatever is creating the tax bill should also be used for paying it.
Some retirees are hit with underpayment penalties because their income exceeds their expectations and they haven’t withheld enough or paid enough in quarterly taxes. At this stage, their taxable accounts may also be generating a large amount of taxable interest and dividend income. The tax bill in April can surprise retirees, but it may also come with penalties from underpayment during the year.
How to Avoid Tax Surprises in Retirement
To avoid unexpected taxes in retirement, it’s best to start planning before you retire or before all your income sources are turned “on”. Being proactive about this can help you identify where the additional taxes may come from and still have time to prevent it. Here are a few actions you can take to be intentional about tax planning:
Asset location adjustments – placing your investments in the appropriate type of account to minimize your taxable income.
Planning which accounts your withdrawals will come from – the order of withdrawals and the amount taken from each type.
Setting up the right amount of tax withholding from your income sources.
Considering Roth conversions before starting RMDs and Social Security benefits to use up the lower tax brackets.
Managing capital gains and offsetting gains with realized losses.
Being aware of income limits for IRMAA and net investment income tax.
For many retirees, the tax planning sweet spot is found in the years after retirement but before starting Social Security and RMDs. Retirees in this phase may temporarily be in a lower tax bracket and have the flexibility to carry out tax planning before their higher income years arrive.
In Summary
Here’s the good news – it’s not too late to review your tax strategy and find ways to lower your lifetime tax bill. Some retirees may feel like the window of opportunity has passed, but in my experience there’s usually something that can be adjusted to save on taxes no matter the phase of life someone is in.
Tax laws also change over time. Your tax strategy should be reviewed annually to see if any changes in your personal situation or tax laws in general require action in your plan. As always, work with your tax professional and financial advisor to improve your tax strategy and implement small changes that can create a larger impact.
Travis
Investment advisory services offered through Andrews Advisory Associates LLC, a registered investment advisor. This blog is not meant to give investment advice. Before investing in any advisory product please carefully read any disclosure documents, including without limitation, the firm’s Form ADVs. The information herein is provided for informational purposes only, and does not constitute an offer, solicitation or recommendation to sell or an offer to buy securities, investment products or investment advisory services. Nothing contained herein constitutes financial, legal, tax, or other advice. These opinions may not fit your financial status, risk and return profile or preferences. Investment recommendations may change, and readers are urged to check with their investment adviser before making any investment decisions.
