3 Retirement Tax Challenges That Can Eat Into Your Savings in a Big Way
From Social Security taxes and required minimum distributions (RMDs) to capital gains and Medicare surcharges, retirees face a variety of tax rules that can quietly increase their tax bill if they're not paying attention. However, understanding how retirement income is taxed can help you keep more of your hard-earned money.
According to tax experts, here are the biggest and most common tax challenges retirees face, along with strategies to guide them.
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1. Home Isn't Always Where the Support System Is
Not recognizing the unspoken value of your support system is one of the biggest ways you can shrink your nest egg without realizing it. If you have hired caregivers coming in to help, who steps in when there is a problem? What is your backup plan and who is close by that can help you?
These are questions posed by Kevin D. Quinn, J.D., President at Legacy Counsellors, PC. “We don’t like to think about frailty," he said. "We like to think about our golden years and living with ease and living peacefully. But it’s a reality, and the truth is you can typically count on family more than anyone else."
Where you retire is an important part of aging in place. If you move to a state simply because it doesn’t tax Social Security or estates, you might not be factoring in all of the hidden costs of moving away from home base.
I see people and even clients move to Florida to avoid estate tax and regularly get sick and go back to New England," said Quinn. "They then spend the rest of their years in New England without the proper estate tax plan because they need the family support system […] I would encourage people to really think about where your support system is and who will be there for you when problems arise."
2. Weighing State Tax Laws Against Social Security
Some people relocate during retirement, often to a warmer state. However, this can affect their tax situation. Rachel Byers, CPA, professor of accounting at Purdue Global and managing partner at Byers, Byers & Associates PC, recommended thoroughly analyzing state tax rules beforehand. "State tax rules vary widely," she said. "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."
Don’t forget that Social Security benefits are taxed or not taxed in varying ways depending on which state you live in. According to Logan Allec, CPA and owner of CPA firm Clarita CPA Group, 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 required minimum distributions (RMDs), especially if you had never taken distributions out of your retirement accounts before and only relied on Social Security income," Allec noted.
That brings us to the final challenge.
3. Navigating 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," said Allec.
These, as mentioned above, are known as required minimum distributions, 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.
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.
Josephine Nesbit contributed to the reporting for this article.
This article was provided by MoneyLion.com for informational purposes only and should not be construed as financial, legal or tax advice.
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