Top 3 Retiree Tax Mistakes and How to Avoid Them
Retirement is a time when many people hope to relax and enjoy the fruits of their labor. However, it’s also a period that requires careful financial management, especially when it comes to taxes. Even a small mistake can lead to significant financial losses, reducing the income you depend on during your golden years. In this blog, we’ll explore the top three tax mistakes retirees commonly make and, more importantly, how you can avoid them. By understanding these pitfalls, you can protect your retirement savings and keep more of your hard-earned money.
Mistake #1: Converting Too Much or Not Enough from Your Roth IRA in Low-Income Years
One of the most common mistakes retirees make involves converting too much or not enough from their Roth IRA during years when their income is low. Roth conversions can be a powerful tool for managing taxes in retirement, but the key is timing and amount.
Understanding Roth Conversions
A Roth conversion is the process of transferring money from a Traditional IRA or 401(k) into a Roth IRA. The primary benefit of a Roth IRA is that, once the money is in, it grows tax-free, and withdrawals during retirement are also tax-free. This can be especially advantageous if you expect your tax rate to be higher in the future.
However, when you convert money into a Roth IRA, the amount you convert is added to your taxable income for that year. This is where things can get tricky.
Converting Too Much: The Tax Bracket Trap
If you convert too much in a single year, you could inadvertently push yourself into a higher tax bracket. For example, let’s say you’re a single filer with a taxable income of $44,000 in 2024. You’re comfortably in the 12% tax bracket, which applies to income up to $47,150. However, if you decide to convert $10,000 from a Traditional IRA to a Roth IRA, your taxable income would increase to $54,000, pushing you into the 22% tax bracket.
This means you’re paying more in taxes than necessary, simply because of the timing and size of your conversion. What could have been a strategic tax-saving move ends up costing you more.
The Medicare Surcharge Dilemma
But that’s not the only consequence. Converting large amounts can also affect your Medicare premiums. Medicare Part B and Part D premiums are based on your Modified Adjusted Gross Income (MAGI) from two years prior. If your MAGI exceeds certain thresholds, you’ll pay higher premiums, thanks to the Income-Related Monthly Adjustment Amount (IRMAA).
For example, in 2024, if your MAGI exceeds $103,000 for single filers or $206,000 for married couples filing jointly, you’ll face higher Medicare premiums. These surcharges can add hundreds of dollars to your annual costs, which can significantly impact your retirement budget.
Converting Too Little: Missed Opportunities
On the flip side, not converting enough can also be a mistake. By failing to convert during low-income years, you might miss the opportunity to move money from a tax-deferred account to a tax-free one at a lower tax rate. This means you could end up paying more in taxes down the road when you’re required to take Required Minimum Distributions (RMDs) from your Traditional IRA, which could push you into a higher tax bracket.
According to a 2020 study by the Center for Retirement Research at Boston College, over 60% of retirees fail to optimize their Roth conversions, leaving significant tax savings on the table. This missed opportunity can result in a higher tax burden later in retirement, when managing your income tax brackets becomes more challenging.
Finding the Sweet Spot
So, how do you find the right balance? The key is to carefully plan your conversions. Work with a financial advisor to assess your current and projected income, tax brackets, and potential Medicare surcharges. By strategically converting smaller amounts over several years, you can minimize your tax liability and avoid unnecessary Medicare surcharges.
Also, keep in mind that the current tax laws, which were implemented under the Tax Cuts and Jobs Act of 2017, are set to expire in 2025. This could lead to higher tax rates in the future, making Roth conversions even more attractive today.
Mistake #2: Not Taking Advantage of the 0% Capital Gains Bracket When Your Income is Low
Another significant mistake retirees often make is not taking advantage of the 0% capital gains tax bracket when their income is low. The tax code provides a unique opportunity for retirees to realize gains on investments without paying any federal taxes, but many miss out on this benefit.
Understanding the 0% Capital Gains Bracket
Long-term capital gains—profits from the sale of assets held for more than a year—are taxed at different rates depending on your taxable income. For 2024, the 0% capital gains tax rate applies to single filers with taxable income up to $47,025 and married couples filing jointly with income up to $94,050. This means if your income is below these thresholds, you could sell investments and realize gains without paying any taxes on those gains.
However, a 2021 IRS report found that less than 5% of eligible taxpayers take advantage of this bracket, missing out on substantial tax savings.
How to Leverage the 0% Capital Gains Bracket
The key to maximizing this opportunity is timing and strategic planning. Here’s how you can do it:
- Identify Low-Income Years: These are typically the years after you retire but before you start taking Social Security or Required Minimum Distributions (RMDs) from your retirement accounts. During these years, your taxable income may be lower, making it easier to stay within the 0% capital gains tax bracket.
- Sell Appreciated Assets: In these low-income years, consider selling investments that have appreciated in value. By doing so, you can realize gains without incurring any federal capital gains taxes. This not only provides you with tax-free income but also resets the cost basis of your investments.
- Resetting the Basis: When you sell an asset, the difference between the sale price and the purchase price (your basis) is your capital gain. By selling appreciated assets and then repurchasing similar securities, you lock in gains at a 0% tax rate and reset your cost basis to the current market value. This means that future gains will be calculated from this new, higher basis, potentially reducing your taxable gains down the road.
Timing and Planning Are Everything
To fully leverage this strategy, it’s crucial to review your income and investment portfolio annually. By doing so, you can identify opportunities to benefit from the 0% capital gains bracket and make adjustments as needed.
This strategy can be particularly beneficial if you have significant investments that have appreciated over time. Instead of holding onto them indefinitely, you can strategically sell and repurchase them during low-income years to minimize your tax liability. When buying and selling, be mindful not to trigger a wash sell.
Mistake #3: Not Understanding the Provisional Income Calculation and Having Your Social Security Income Taxed at a Higher Level
The third mistake that many retirees make is not understanding how their combined income affects the taxation of their Social Security benefits. This mistake can lead to a significant portion of your Social Security income being taxed, reducing the benefits you rely on during retirement.
What Is Provisional Income?
Provisional income is a measure that the IRS uses to determine how much of your Social Security benefits are taxable. It’s calculated as follows:
- Adjusted Gross Income (AGI): This includes all taxable income, such as wages, interest, dividends, and distributions from retirement accounts.
- Nontaxable Interest: This includes income that is not subject to federal income tax, such as interest from municipal bonds.
- Half of Your Social Security Benefits: Add 50% of your total Social Security benefits to the above amounts.
The resulting figure is your combined income. The IRS uses this figure to determine what portion of your Social Security benefits is taxable.
Taxation Thresholds for Social Security Benefits
For 2024, the IRS has set the following thresholds for taxing Social Security benefits:
- Single Filers:
- Provisional income between $25,000 and $34,000: Up to 50% of your benefits may be taxable.
- Provisional income above $34,000: Up to 85% of your benefits may be taxable.
- Married Couples Filing Jointly:
- Provisional income between $32,000 and $44,000: Up to 50% of your benefits may be taxable.
- Provisional income above $44,000: Up to 85% of your benefits may be taxable.
According to the Social Security Administration, about 40% of beneficiaries pay taxes on their Social Security benefits, often because they don’t manage their other income sources properly. This can result in a significant reduction in the net amount of Social Security income available to you during retirement.
How to Manage Combined Income and Minimize Taxation
To avoid having too much of your Social Security benefits taxed, it’s essential to manage your combined income carefully. Here are some strategies to consider:
- Delay Social Security Benefits: By delaying the start of your Social Security benefits, you can reduce your combined income during the early years of retirement. This can help you avoid crossing the thresholds that trigger taxation of your benefits.
- Stagger Retirement Account Withdrawals: Instead of taking large lump-sum withdrawals from your retirement accounts, consider spreading them out over several years. This can help you manage your taxable income and keep your combined income below the critical thresholds.
- Roth Conversions: As mentioned earlier, converting Traditional IRA funds to a Roth IRA in low-income years can help manage your taxable income in future years, potentially reducing the amount of Social Security benefits that are subject to tax.
- Consider Tax-Exempt Investments: Investments that produce tax-exempt income, such as municipal bonds, can help lower your adjusted gross income and, therefore, your combined income.
By implementing these strategies, you can better manage your taxable income, potentially reducing or eliminating the taxes on your Social Security benefits.
Conclusion
Retirement is a time to enjoy the fruits of your labor, but it’s also a time when careful tax planning becomes crucial. The three mistakes we’ve discussed—converting too much or too little to a Roth IRA, not taking advantage of the 0% capital gains tax bracket, and misunderstanding the combined income calculation—can all have significant financial consequences.
By understanding these common pitfalls and taking proactive steps to avoid them, you can protect your retirement savings and ensure that you’re making the most of your financial resources. Whether you’re already retired or planning for the future, now is the time to review your tax strategy and make adjustments as needed.
If you found this information helpful, I encourage you to share it with others who might benefit. And if you need personalized advice tailored to your unique situation, feel free to book a consultation with me at The Hourly Advisor. Let’s work together to make your retirement as financially secure as possible.