7 Things Retirees Need To Know About Filing Income Tax Returns
Written by
Jennifer Taylor
Edited by
Chris Cluff
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You might be retired, but that doesn’t mean you’re free from Uncle Sam. Although you’re no longer collecting a paycheck from an employer, you probably still have to pay income taxes.
Filing is a little different when you’re employed, so it’s important to be in the know. You may also be surprised by exactly how much you’ll owe.
“Many retirees incorrectly assume their taxes will go down in retirement,” said Dan Pinheiro, CFA, CFP, wealth manager and founder at South Coast Planning and Wealth Management. “However, the combination of tax-deferred accounts, RMDs [required minimum distributions] and Social Security can make taxes and retirement a complicated situation to navigate.”
You probably wouldn’t be thrilled to be surprised with a hefty tax bill, so staying on top of your finances is important. Here’s some advice to help optimize your tax payments in retirement.
Take Required Minimum Distributions
“Once retirees reach their required minimum distribution age, they are typically required to take minimum distributions from their traditional IRAs and other retirement plans,” Pinheiro said. “Failure to take RMDs can result in substantial penalties.”
Therefore, he advised planning the timing and amount of these distributions wisely, to manage your tax liability.
Some Healthcare Expenses Are Tax Deductible
“Retirees often have significant healthcare expenses, including premiums for Medicare, and other out-of-pocket costs,” Pinheiro said. “Certain medical expenses may be deductible if they exceed a certain percentage of the retiree’s adjusted gross income (AGI).”
He said you might also have access to tax credits and deductions — i.e., the Senior Tax Credit — as well as those related to charitable contributions, property taxes and other expenses.
Always Make Estimated Tax Payments
If you think you don’t need to make estimated tax payments, you’re not alone. Noah Damsky, CFA, principal at Marina Wealth Advisors, said this is the number one tax mistake he sees retirees make.
“Without regular tax withholding from a paycheck, it’s critical to send estimated tax payments throughout the year,” he said. “If you distribute from an IRA or have rental real estate income, it’s critical to make payments throughout the year, so you don’t get slapped with penalties and interest.”
Be Mindful With Qualified Charitable Distributions
“If the retiree is age 70 and a half or older and has done a qualified charitable distribution (QCD) from their IRA, the tax form 1099-R does not list anything specifically about the distribution being a QCD,” said Maggie Klokkenga, CFP, CPA, financial planner at Abundo Wealth.
She said this is a conversation you need to have with your tax preparer.
“Otherwise, instead of the QCD reducing their taxable income, the tax preparer may erroneously include it as taxable income,” she said. “That’s essentially double-counting it, and not in a good way.”
Social Security Income is Taxable
“Up to 85% of your Social Security benefit might be included in your taxable income,” said Justin Pritchard, CFP at Approach Financial, Inc. “That’s a surprise to many, as they think it’s all tax-free.”
If Social Security is your only source of income, he said you might not owe taxes on your benefit.
“But if you also withdraw from IRAs or 401(k) plans to supplement your income, there’s a good chance that you’ll pay tax on some portion of your benefits,” said Pritchard.
Plan To Owe Taxes on Pre-Tax Retirement Account Expenditures
If you spent money on pre-tax retirement accounts, Pritchard said you will probably owe income tax.
“That money has never been taxed, so it’s going to happen sooner or later,” said Pritchard. “You reduced your income when you added money to those accounts, so you typically need to pay tax when spending that money.”
Earned Interest Can Be Taxed
“You might earn interest in bank accounts or get dividends and capital gains in taxable investment accounts,” Pritchard said.
He said those earnings can be a tax liability.
“Interest is generally treated as ordinary income, but some dividends and capital gains get better tax treatment,” said Pritchard. “Long-term capital gains and qualified dividends might be taxed at lower rates than ordinary income.”
How To Avoid a High Tax Bill
If your tax bill is too high, Pritchard said it’s best to take action as soon as possible, so you don’t have to do anything drastic.
“For example, you can convert pre-tax money to Roth, but doing so requires a bigger tax bill in the year you convert,” he said. “Future withdrawals from the Roth account might be tax-free if you satisfy IRS requirements.”
He said you can also be mindful about which types of accounts you’re spending from.
“If you’re nearing a high tax bracket or your income is getting too high, it might make sense to draw from taxable or Roth accounts,” he said. “Perhaps you can sell mutual funds or ETFs that do not have a large capital gain.”
Using these strategies can potentially allow you to stay in a low tax bracket, thus minimizing the amount of Social Security you’ll be taxed on, he said.
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