Retirement Tax Strategies
Retirement is a very desired period in a person’s life. There is time to finally enjoy the fruits of their labor and relax, while also developing and pursuing their interests and hobbies. An individual’s retirement experience is significantly affected by the level of financial planning that has taken place in the years leading up to retirement. This article will discuss strategies that can help ease the burden of taxes and potentially elongate savings.
How Social Security is Taxed
The provisional income formula determines how Social Security is taxed while working and in retirement. Much like federal tax brackets, Social Security is broken down into different cutoff points in which a person’s taxes may increase or decrease depending on the bracket they fall into.
For singles and head of household filers, if provisional income is under $25,000, then 0% of a person’s Social Security will be taxed. If a person’s provisional income falls between $25,000-$34,000, then Social Security can be taxed up to 50%. For a person that has a provisional income higher than $34,000, up to 85% of Social Security benefits can be taxed.
For married couples or others filing jointly, the following are the brackets for Social Security tax purposes. If provisional income is lower than $32,000, then 0% of Social Security will be taxed. For couples making between $32,000-$44,000, up to 50% of their Social Security is taxable. For joint filers making over $44,000, 85% of Social Security benefits are taxable.
These thresholds are important to keep in mind when making financial decisions in retirement because they can significantly affect the amount of Social Security benefits a person may receive.
Provisional Income Formula
Provisional income, as defined by the Social Security Administration, is ordinary income + 50% of annual Social Security benefits + 100% of tax-exempt interest generated via investments + 100% of dividends and capital gains.
Roth Conversion Strategies
Roth IRA conversions refer to the transfer of funds from within a traditional IRA into a Roth IRA, which is an account in which after-tax dollars are contributed. Roth IRAs allow investors to withdraw funds starting at age 59 ½ without any taxes or penalties. So why wouldn’t everyone contribute to Roth accounts? They can’t. Individuals making over $140,000 and married couples filing jointly making over $208,000 (2021 thresholds) are barred from making contributions to Roth IRA accounts. Although this is the case, there are ways to still contribute to a Roth even if you are over the income threshold. The following strategies can be applied to the process of converting a traditional IRA into a Roth:
The back door conversion is a strategy used by people who have income above the allowable threshold for Roth IRA contributions. Using this strategy, a person can contribute money into their traditional IRA and then roll over those funds into a Roth, even if the sum exceeds the annual contribution limit for the account. This method can also be used to convert a 401k into a Roth IRA, but only if a person’s company plan allows for conversions.
Conversions can take place in several different ways. A person can decide to do a 60-day indirect rollover, which consists of receiving distribution in the form of a check paid from a traditional IRA account. That person then has up to 60 days to deposit the check directly into a Roth account.
The preferred method for our firm is a trustee-to-trustee direct transfer, which involves instructing a person’s traditional IRA provider to transfer funds into an account held by that person’s Roth IRA provider. A same-trustee direct transfer takes place when a person holds both their traditional and Roth IRA accounts at the same institution and instructs them to transfer the money between the accounts.
Planning for RMDs
Required minimum distributions (RMDs) are sums of money that a person must withdraw annually from qualified accounts under US tax law. The IRS requires people aged 73 and older to distribute money from traditional IRAs and other employer sponsored retirement accounts, such as a 401(k) or a 403(b). Failure to withdraw the required amount of money may result in large fines from the IRS, which could total up to 25% of funds that should have been withdrawn.
It is important to plan properly for RMDs to avoid increasing taxable income and percentage of Social Security taxation in retirement. If a person has multiple employer sponsored retirement accounts, such as a 401(k), they may be required to take RMDs for each account. For money held in different IRA accounts, a person can add up individual RMD amounts and withdraw the total from whichever account they prefer.
One consideration to keep in mind is that making small, penalty free distributions before a person turns 73 may relieve the burden of the high distribution amounts. Another method to lessen the impact of RMDs is to perform a traditional IRA conversion into a Roth IRA account, which do not have required distributions. If the income from RMDs is beyond what a person needs for a comfortable retirement, then there are options to redistribute this money with minimal additional taxes. Placing the RMD money into an account to cover surprise medical expenses can allow retirees to be comfortable in perpetuity. Taking RMD funds and purchasing an irrevocable life insurance trust allows a person’s heirs to receive a large death benefit from the policy with no additional taxes. There is also a method to donate RMD money tax-free directly from an IRA to any 501(c)(3) registered charity. This is called a Qualified Charitable Distribution (QCD) and it allows for an individual to distribute the funds without having to pay income tax on the funds.
When to take Social Security
The official age that a person is allowed to begin taking Social Security benefits is 62, but delaying payments can have positive results for those who are able to postpone. Benefits can be postponed up to age 70 and this results in the highest monthly payments. There is no one-size-fits-all answer to when a person should start collecting, but there are some determining factors that can help answer the question. Full retirement age is the time when the IRS considers a person of age to receive full Social Security benefits. This is a sliding scale depending on the year a person was born. If a person is born in 1955 or later, their retirement age is anywhere from 66 years & 2 months old, all the way to 67 years old if born after 1959. Any person born before 1955 is deemed full retirement age by the IRS. There is a reduction of benefits if Social Security is taken before retirement age and the loss of income will last throughout retirement.
One key consideration is cash needs during retirement. If a person is ready to retire and they have a strong, diverse portfolio, they can delay their benefits as they will have sufficient funds to maintain quality of life in retirement. Another component to consider is life expectancy. If someone is planning to live to a very old age, then delaying benefits in order to receive larger payments is a good option. The breakeven point is when a person has received the same amount of benefits as they have paid into the system, so people should be conscious of where and when their breakeven point is in order to make it past that and realize the most benefits possible. If married, a person should carefully consider when to take their benefits in relation to their spouse, as the amount of benefits for a lower-earning spouse is determined by the higher-earning spouse in the case of death of the higher-earner. Lastly, if a person is still working near or after retirement age, then their Social Security benefits will be reduced for any more earned above the annual limit ($18,960 in 2021 for people pre-retirement age, $50,520 in 2021 for people of retirement age).
Additional Medicare Premiums
Medicare Part A, which covers hospital insurance, usually does not carry a monthly premium due to the fact that most people pay Medicare taxes while working. If a person did not contribute to Medicare while working, then their monthly premium will be $499, with additional costs added for hospital or skilled nursing facility stays. For Medicare Part B, which covers medical insurance, there is a yearly deductible of $233 per year along with monthly premiums. The standard monthly premium for Part B in 2022 is $170.10, but at the top of the scale single people making over $500,000 or married couples making over $750,000 have a monthly premium of $578.30. For Part C, advantage plans, there is no monthly premium but it requires co-pays for visits of almost any kind. Part C is utilized in most HMO care plans offered to retirees. Medicare Part D, which covers prescription drugs, has a national base beneficiary premium of $33.37. In addition to this cost, there are monthly premiums paid in addition to Part B premiums that range from $0 if making under $91,000 as a single or $182,000 as a couple, up to $77.90 if making over $500,000 as a single or $750,000 jointly.
Working Tax Strategies
The following strategies and considerations are important to keep in mind as they can lead to changes in taxable income that can serve to help or hurt a person’s style of living in retirement.
Controlling Capital Gains & Dividends
Capital gains are incurred anytime a person sells an asset and makes a profit. Taxes are paid based on the money that is earned when the asset is sold. These assets can include stocks, real estate, or any other taxable asset. This money will be taxed using either short-term or long-term capital gains tax, with the cut-off being if the asset is held for more or less than one year. Short-term gains are taxed as regular income, meaning they can affect the tax bracket a person falls into in any given year. For long-term gains, there are three basic brackets in which a person can be taxed at; 0%, 15%, or 20%. The tax rate bracket for this type of income depends on a person’s taxable income for the year. There is also an additional 3.8% Net Investment Income Tax (NIIT) if a person’s adjusted gross income is above $200,000 individually or $250,000 jointly.
Dividends are taxed based on being a qualified or non-qualified dividend. Qualified dividends are taxed at the same rate as long-term gains, which places individuals in one of the three tax brackets. Non-qualified dividends are counted as ordinary income, which could have a major effect on a person’s tax bracket for any given year. If an individual owns shares of mutual funds that are regularly managed, this may be preventing the holdings from producing qualified dividends due to the fact that the individual stocks are not being held for over a year. This is a key consideration that our firm looks at to determine how to lower the tax burden for our clients.
Standard vs Itemized Deductions
Standard deductions help reduce a person’s taxable income via a set rate that is determined by the federal government via filing status. The standard deduction for a couple that is married filing jointly for 2022 is $25,900, which is an increase of $800 over the last year. Taxpayers that are excluded from using a standard deduction, such as a married couple whose spouse itemized their deductions or a non-resident alien, can itemize their deductions in order to still receive tax benefits. Others can also itemize their taxes simply for the reason that the deduction will be bigger than the standard they were set to receive. Typically, a taxpayer will itemize their deduction for things such as state and local income taxes, real estate taxes, mortgage interest taxes and mortgage insurance premiums, and donations to charity, among others. There are also specialized deductions for people over the age of 65, those who are legally blind, and several others. Each of these factors and their accompanying deductions should be taken into consideration when deciding between a standardized or itemized deduction. Speaking with someone qualified in deductions can help determine whether it is smart for a person to itemize their deductions or take the standard.
Real Estate Depreciation
Real estate depreciation is the deduction a person can take on their owned properties to account for continuous use of a space. Taxes can be deducted via the income generated by the asset or by using the cost of improvements to the property. It is important to note that the value of land is not taken into account for depreciation determinations because land typically appreciates in value over time. People can deduct depreciations to their own property as well as rental properties that they own, which can lead to large tax savings. Accelerated depreciation is a method that deducts an asset’s depreciation at a faster rate than the traditional method. This can lead to tax breaks in the early years of owning a real estate asset, which can then be redistributed into various accounts, such as a Roth IRA.
Allocation of Investments in Appropriate Vehicles
Deciding on what investments are right for a person starts with determining what the goals of the investment are. There are a plethora of investment vehicles an investor may choose from, so determining the proper ones for each individual is the key. For people looking for low-risk investments; savings accounts, certificates of deposit, money market accounts, bonds, and precious metals, among many others, are safe options. Although there is less risk involved in these types of investments, the return on investment is usually significantly lower than other investment vehicles. People that seek high returns can make high-risk investments in areas such as cryptocurrency, hedge funds, certain ETFs, and real estate-based securities, among countless others. These investment vehicles offer large growth opportunities, but investors must be willing to risk losing their invested money. High income earners should be weary of the fact that holding money in taxable accounts increases a person’s taxable income for the year. Thus, allocating funds into Roth IRAs or tax-deferred accounts can help lower taxable income and provide tax relief.
Argument for Annuities
Annuities have many uses and benefits for people with specific needs. First, it is important to understand the different kinds of annuities; immediate, fixed, variable, and indexed. Immediate annuities are like pensions and Social Security. You are guaranteed a stream of income for the rest of your life, but when you pass that income stops and no principal is left behind for the next generation. Fixed annuities are those that have a preset or guaranteed interest rate, meaning they will always provide a return, but it will be relatively low due to their low risk and minimal growth. (Similar to a CD but the interest is tax deferred until you remove it from the fixed annuity). Variable annuities are tied to specific investments, such as different mutual funds, and have the opportunity for the highest returns but are also considered a much higher risk investment. (Also, typically have the highest fees of all the annuities). Indexed annuities take from both fixed and variable in certain aspects, they promise a minimum guaranteed return on investment via interest and/or a return based on a market index, such as the S&P 500. Indexed annuities typically only have interest gains based off of the premiums paid rather than the entire policy and have a smaller market-based return than the actual market percentage gains.
Fixed and most indexed annuities have premium protection, meaning an investor will typically not risk what they initially paid. This makes these annuities attractive options for income deferral for people looking to make a safe investment. Most annuities also can assure joint income for life. There are options to allow the annuity to outlive the purchaser and continue to distribute benefits to a spouse or family member. Another benefit for some annuities is the ability to add long term care options that can help cover costs of medical care in retirement. From a financial standpoint, annuities are a method to grow tax-deferred contributions, meaning the money that a person earned will not be taxed until it is time to take distribution payments.
Where We Want Income Producing Assets vs Growth Assets
Income producing and growth assets each hold distinctive advantages and features that make them both important factors to a person’s portfolio. Income producing assets are investments that are made in order to ensure a consistent stream of revenue over time. Some examples of income producing assets are dividend-paying stocks, certificates of deposit, structured notes and rental properties. Growth assets are investments and other vehicles that focus on increasing capital. Some examples of these assets include growth stocks and growth funds, which typically have no dividends payments. The stage of life a person is in and their goals for the future are important considerations when deciding between investing in different assets. If having a higher return on investment and capital gains in a more short-term period with higher risk is important to a person, then growth assets are a great option. If consistent growth and income at lower rates but with less risk is important to an investor, then income producing investments are the best route. Having a mix of both kinds can provide opportunities to minimize taxes while also providing consistent income. The diversification of portfolios aids in the process of investing.
Investment advisory services offered through Foundations Investment Advisors, LLC (“Foundations”), an SEC registered investment adviser. Ben Fuchs authors this commentary which may include information and statistical data obtained from and/or prepared by third party sources that Foundations deems reliable but in no way does Foundations guarantee the accuracy or completeness. Foundations had no involvement in the content and did not make any revisions to such content. All such third-party information and statistical data contained herein is subject to change without notice and may not reflect the view or opinions of Foundations. Nothing herein constitutes legal, tax or investment advice or any recommendation that any security, portfolio of securities, or investment strategy is suitable for any specific person. Personal investment advice can only be rendered after the engagement of Foundations for services, execution of required documentation, including receipt of required disclosures. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Foundations manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. All investments involvement risk and past performance is no guarantee of future results. Advisory services are only offered to clients or prospective clients where Foundations and its advisors are properly licensed or exempted. For more information, please go to https://adviserinfo.sec.gov and search by our firm name or by our CRD # 175083. Rates and Guarantees provided by insurance products and annuities are subject to the financial strength of the issuing insurance company; not guaranteed by any bank or the FDIC.
