5 Tax Traps Retirees Can Fall Into — and How To Avoid Them
Written by
Josephine Nesbit
Edited by
Brendan McGinley
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Most people look forward to retirement, but it can also introduce new tax challenges that catch many retirees off guard. Even one small mistake can potentially cost retirees hundreds or even thousands of dollars.
According to tax experts, here are the most common tax traps retirees fall into, along with strategies to avoid them.
1. Forgetting About Required Minimum Distributions
“The tax code requires that, once they turn 73 years old, owners of certain retirement plans such as traditional IRAs, traditional 401(k)s, 403(b)s, 457(b)s, SEPs and SIMPLE IRAs must take out of these accounts at least a certain amount of money each year,” Logan Allec, CPA and owner of CPA firm Clarita CPA Group, wrote in an email.
These are known as required minimum distributions (RMDs), and according to Allec, the RMD amount is generally the balance at the end of the previous year divided by a life expectancy factor published by the IRS in Publication 590-B.
“Most custodians or retirement plan administrators these days will calculate your RMD for you — at least for the accounts you hold with them — and inform you of it either on their website or via email or paper mail,” he claimed.
And if you don’t take out your RMD by the end of the year, you’ll be charged with a 25% excise tax on the RMD amount that you failed to withdraw. “If you fix your mistake and take out the appropriate RMD within two years, that 25% cuts down to 10% — still an expensive mistake, nevertheless!” Allec added.
2. Not Considering State Taxes
Some people relocate during retirement, often to a warmer state, but this can affect their tax situation. But Rachel Byers, CPA, professor of accounting at Purdue Global and managing partner at Byers, Byers & Associates PC, recommends thoroughly analyzing state tax rules beforehand.
“State tax rules vary widely. Retirees who consider relocating to a state that doesn’t have a state income tax must consider the impact that property tax rates, sales tax rates and estate/inheritance tax rules will have on their overall financial situation,” Byers wrote in an email.
Also, Byers pointed out that some states offer exemptions or deductions for certain types of retirement income, such as defined benefit pensions or public (state/local) pensions, or based on age or income level, while others do not.
3. Thinking Social Security Benefits Are Never Taxed
According to Allec, some mistakenly believe that Social Security benefits are tax-free, but this is not the case.
“While it is true that your benefits will be completely tax-free if they are the only income you receive, up to 85% of your Social Security benefits may be taxable if you receive income other than your Social Security benefits,” he said.
But how much of your Social Security benefits are taxable depends on your filing status, the amount of your Social Security benefits and the amount of income you receive outside of your Social Security benefits.
“Where a misunderstanding of how Social Security benefits are taxed can really become a nasty trap is in that first year that you take your RMD, especially if you had never taken distributions out of your retirement accounts before and only relied on Social Security income,” Allec noted.
Allec also pointed out that this can create a situation where you aren’t paying any income taxes because your only income was from Social Security, but once you have to start taking your RMDs, it could cause a portion of your Social Security benefits to be taxable going forward.
If possible, Byers recommends Roth IRA withdrawals rather than traditional IRA/401(k) withdrawals and delaying or expediting the sale of capital gain assets to a particular tax year.
“Oftentimes, retirees are not able to delay the receipt of taxable retirement income (IRA distributions and pensions) to avoid the tax on the Social Security benefits due to required minimum distribution (RMD) rules,” she added.
In such situations, Byers wrote that estimating total annual income is necessary for tax planning. “Retirees can request that the Social Security Administration withhold taxes from the monthly benefit to help spread the tax burden throughout the year,” she wrote.
4. Not Keeping Up With Tax Law Changes
Tax laws do change, especially with each new administration, Allec pointed out.
“In addition to the obvious $6,000 senior deduction, there are other tax law changes potentially affecting seniors in the recently passed One Big Beautiful Bill Act,” he noted.
This includes:
- An increased SALT (state and local tax) cap deduction, which will benefit retirees who itemize and pay large amounts of property taxes.
- A 0.5% floor on itemized charitable contributions, which affects retirees who itemize and give larger amounts to charity.
- A reduction in the gambling loss deduction to only 90% (formerly 100%) of gambling losses against winnings.
5. Being Too Aggressive With, or Not Completing, Roth Conversions
A common trap Chad Gammon, CFP, RICP, EA and owner at Custom Fit Financial, sees is with Roth conversions in retirement.
“This can either be with too aggressive of a Roth conversion or not completing any Roth conversions. I’ve seen people fill up a tax bracket that is too high if they smoothed out the Roth conversions over time,” Gammon said. “Going back to tax planning can help give an overall picture of tax impacts and overall savings.”
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