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5 Tax Mistakes to Avoid in Retirement

Retirement – a time of rest and relaxation. However, just because you don’t have to work anymore doesn’t mean you shouldn’t let your guard down regarding your finances. Your sizeable nest egg can be quickly and needlessly reduced not by investment errors but by simple tax planning mistakes. In this article, we review some of the more common or significant mistakes one can make in retirement and how to avoid them. 

1. Deferring Taxes on All of Your Retirement Plan Contributions

When you contribute to your Traditional 401(K) or IRA, you can claim a tax deduction for that year, potentially keeping you in a lower tax bracket. But what if all your retirement plan savings are solely in tax-deferred accounts? In that case, you’re going to end up paying taxes on all of your contributions and their gains in retirement, and you will have a lot less flexibility as to when and how you pay your tax bill, especially once Required Minimum Distributions kick in. 

Instead, make both Traditional contributions for the deduction and Roth contributions for tax-free distributions. That way, you’ll be able to pick and choose what accounts to pull from to help you keep taxes low. For example, if you’re on the edge of a tax bracket and a withdrawal from your Traditional account would push you over the edge, but you need the cash, you could choose to pull from your Roth instead. Alternatively, if you are in a low-income year, you could decide to withdraw more from your Traditional accounts so you’ll pay less taxes while letting your tax-free Roth funds continue to grow. 

A tax-efficient withdrawal strategy is absolutely vital for ensuring your retirement savings remain on the path of least resistance. Every financial situation is unique, but a common rule of thumb would be to withdraw funds from taxable accounts first, then tax-deferred accounts, and finally save the tax-free accounts for later in life, giving them more time to grow tax-free with the added benefit of no Required Minimum Distributions.

2. Not Planning for Required Minimum Distributions (RMDs)

Once you reach 73 years old, you must begin withdrawing from your Traditional retirement accounts. Forgetting or failing to withdraw an RMD can lead to hefty penalties. While Secure 2.0 did lighten penalties, they are still substantial. 

Post Secure 2.0, the portion of your RMD you fail to withdraw will face a 25% excise tax. So, if your RMD is $1,000 and you only take out $500, you will owe 25% on the $500 you failed to withdraw. However, by promptly correcting your mistake, you can potentially reduce the penalty to only 10%. Still, every dollar counts in retirement – why give the IRS extra funds that you could probably spend better? 

Another common oversight is failing to determine how Required Minimum Distributions (RMDs) will impact both your tax and investment strategy. Many retirees mistakenly believe that they will be in a lower tax bracket in retirement. However, the more pre-tax funds you have in your IRA, the higher your RMD will be, and it could even push you into a higher tax bracket. You can help mitigate an RMD’s effects by converting traditional pre-tax funds into post-tax Roth funds. However, a careful analysis should be conducted before converting to Roth to determine if and how one would be advantageous for your situation. As they are highly technical, we strongly advise calling us for an analysis of your potential ROTH conversion scenarios.

RMDs can also affect your asset allocation. If your portfolio isn’t strategically balanced, you might be forced to sell off assets from your Traditional retirement accounts in a way that could disrupt your intended asset allocation and tax strategy. Such actions could necessitate additional sales or purchases in other accounts to maintain your investment balance, potentially leading to further tax liabilities or unexpected costs.

3. Forgetting State Tax Implications

If you live in Florida, you can rest assured knowing that the state won’t come for your retirement income – not your retirement account distributions, your Social Security benefits, your pension, or any other forms of retirement income. 

Besides Florida, you can also avoid paying state income tax of any sort in Alaska, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. Other states also have various exemptions and rules on specific forms of retirement income, such as from 401(K)s, IRAs, or Social Security benefits, so it’s essential to have a consultation with a local expert to ensure your strategy aligns with local laws.

If you’re in a state that taxes your retirement income, your tax bill may affect how much you will withdraw and your overall investment strategy. You may realize that by staying in a tax-heavy state, your retirement savings won’t last as long as you thought.

4. Not Accounting for Social Security Taxation

This is a big surprise for many. Yes, your Social Security benefits are taxable; the higher your taxable income, the more your benefits will be taxed. In fact, up to 85% of your Social Security could face taxation, depending on the size of your ‘combined income.’ 

To determine your combined income, you combine your adjusted gross income (AGI) with any tax-exempt interest income you have and half of your Social Security benefits. In case you were wondering, your AGI includes your taxable income from your retirement plans. 

For individual taxpayers, if your combined income ranges from $25,000 to $34,000, you may face taxes on up to 50% of your Social Security benefits. If your income exceeds $34,000, up to 85% of your benefits could be taxable. For married couples filing jointly, these income brackets adjust to between $32,000 and $44,000 for a potential 50% taxation rate and over $44,000 for a possible 85% tax on benefits.

To be clear, we do not mean you will owe 85% of your Social Security to the IRS. Instead, 85% refers to the portion of your benefits that can be considered taxable income and will be subject to your tax bracket’s rate.

Notably, though, Roth distributions do not count as taxable income, don’t affect your AGI, and will not affect the taxation of your Social Security benefits. That’s why it’s important to have a sizeable amount of tax-free income in retirement to help compensate for the tax status of your other income sources.

5. Mishandling Capital Gains Taxation

Capital gains are incurred upon selling an investment asset, such as stock or real estate. 

There are two types: short-term for assets held less than a year, taxed as ordinary income, and long-term for those held longer, often taxed at a lower rate. It is possible to reduce your tax obligation by offsetting a portion of your gains with losses in the same category, especially as a part of a rebalancing process. 

Alternatively, it may make sense to offload winning assets while in a lower tax bracket to minimize your burden, also known as tax-gain harvesting. As we mentioned above, managing your regular brokerage accounts alongside tax-advantaged retirement accounts is crucial for a holistic and seamless process. Unexpected capital gains, especially those from mutual fund distributions, can significantly affect your tax and investment situation.

Bonus: Inefficient Charitable Giving Strategies

It’s common for retirees to donate a portion of their savings for tax reasons on top of philanthropic intentions. However, one mistake Americans may make is selling an asset, taking out a Required Minimum Distribution, withdrawing the cash, paying taxes on the withdrawal, donating the desired amount, and claiming the deduction. 

A possibly more efficient method would be to transfer the funds directly from your Traditional IRA or 401(K) to the charitable organization, known as a Qualified Charitable Distribution (QCD). A QCD can simultaneously fulfill RMD requirements while avoiding the tax obligation associated with a withdrawal. This is because the funds from the sale of the asset never reach your hands – instead, they go directly to charity.

In Conclusion

Taxes are often one of the most significant expenses in retirement, and every dollar you pay in tax is a dollar not invested, putting a drag on your investment performance and retirement readiness. Furthermore, overlooking critical factors like Required Minimum Distributions (RMDs), effective tax withdrawal strategies, state tax implications, capital gains taxation, and the tax treatment of your Social Security benefits can not only diminish your retirement lifestyle but even put your retirement at risk!

That’s why it is essential to work with dual-focused wealth managers and tax advisors who can create the most tax-efficient path for your retirement savings. They can help you balance your investment and tax planning, ensuring you maximize your hard-earned retirement savings. 

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For informational and educational purposes only and should not be construed as specific investment, accounting, legal or tax advice. Certain information is based on third-party data and may become outdated or otherwise superseded without notice. Third-party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. The scenario mentioned in this presentation is not an actual client experience. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this presentation.

About the Authors

  • Douglas Walters

    Doug is the Managing Partner of Walters Strategic Partners, LLC, a licensed Registered Investment Advisory firm. Doug is a licensed Certified Public Accountant (CPA) in the state of Florida and holds a Series 65 Investment Advisor Representative securities license. He is also a member of the AICPA. With over 28 years of experience as a CPA, he believes investment decisions should be based on decades of peer-reviewed research rather than relying on the latest “hot tip” from media outlets. This empirical evidence puts the science of investing to work for his clients.

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  • Jose Joia

    Jose M. Joia is a Wealth Advisor at Walters Strategic Advisors, LLC. As a member of the team, Jose’s responsibilities involve comprehensive wealth management, planning and customer service. He has over 6 years of industry experience specializing in planning and solving unique issues his clients encounter. Jose has experience serving individual clients, business owners and non-profit organizations.

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