Don't get caught with a huge tax bill. What new retirees can do to avoid one.
While most Americans look forward to a retirement filled with relaxing moments, accountants warn that unless you’re prepared, the months leading up to April 15 may feel very different.
April 15, dubbed Tax Day, is usually when income tax returns are due. Already, many people dread it, but for new retirees, Tax Day can feel even worse.
Retirement changes your income sources and introduces new tax laws that can confuse many people, accountants said. Knowledge, preparation and not being afraid to engage a tax professional for advice could ease the pain, though, they said.
“Today’s retirees have a more complex financial system than previous groups of people who were retiring,” said Mark Steber, chief tax officer at tax preparer Jackson Hewitt. “This is especially true when looking at the variety of savings and retirement plans of today’s retirees.”
Where your money comes from matters
The change in income sources tends to trip up many retirees, accountants said.
“Income composition is different,” said Miklos Ringbauer, a certified public accountant in Los Angeles. “Before retirement, you heavily rely on W2s with automatic withholdings or pay estimated taxes. Now, no work means no (automatic) withholding,” meaning retirees must manage their withholdings.
Retirees’ income usually comes from one or more of the following: taxable brokerage accounts, pretax investments like 401(k)s, nontaxable accounts like a Roth IRA, or Social Security benefits. Each of those has different tax rules around them. Generally, some, like Roth accounts, have tax-free withdrawals, while taxable brokerage accounts may require capital gains tax, pretax retirement funds are taxed as income and a portion of your Social Security may or may not be taxed depending on income thresholds.
Confused? If you’re not sure if your income is taxable, the IRS has information and interactive tools to help.
Without knowledge and preparation, you may face a big “shocking” tax bill come April, Ringbauer said.
Once retirees know if their income is taxable, they should complete a form for withholdings on taxable accounts, he said.
But determining what percentage to use for withholdings can be tricky, Ringbauer said. “If it’s too big of a withholding, then you may not have enough to spend and have to withdraw more money, which could be more taxes,” he said. If it’s too little, you may owe a lot of money. Consulting with a tax pro can help you determine the right percentage, he said.
How much income you withdraw matters
The amount of money withdrawn or received also changes in retirement, and the way it is done can affect a retiree’s taxes, Ringbauer said.
When “income changes, you may not be so sure what (income) bracket you’ll be in,” he said. “You may be in a 35% tax bracket, but when there’s no wage anymore, what’s your next bracket? It’ll be driven by income requirements. Say that’s $5,000 per month, but what about unexpected expenses that you take out money for? That could push you into a higher bracket.”
Higher income can also push up your Medicare premium and how much of your Social Security gets taxed, experts warned.
“Determining taxability of a portion of your Social Security is (especially) confusing,” Steber said. “You need to use the worksheet provided by IRS or work with a tax pro who understands these forms.”
Tax tips for retirees
Experts offered some tips for retirees, including:
◾Details matter. “My top tip is to keep track and have detailed records of all Forms 1099s from your retirement accounts, Social Security Administration account details and activity, passive and investment income, such as interest and dividends. This also includes the underlying details and balances for all of their respective accounts,” Steber said.
◾To keep taxes low, consider changing investments to tax-free municipal bonds, not taking more out of retirement than needed, and ensuring that there are withholdings on retirement benefits, Steber said.
◾Don’t forget the additional $1,550 standard deduction for each taxpayer age 65 or older filing as married filing jointly, married filing separately, and qualifying surviving spouse and $1,950 for those filing as head of household or single.
◾If your retirement income is lower and you require more medical care as an older person, you may more easily meet the threshold to deduct unreimbursed medical expenses, Ringbauer said. You can deduct unreimbursed medical expenses that exceed 7.5% of your adjusted gross income.
◾Consider state and local deductions. Some places offer credits for property tax for people when they reach a certain age or tax exemptions for some retirement income, Ringbauer said.
◾Do a midyear and near year-end tax projection to avoid surprises when retirees file their tax return, Steber said.
◾If this all seems confusing, consider seeking help. You can hire a tax professional or consult with organizations, like AARP, that offer free tax help.
Medora Lee is a money, markets and personal finance reporter at Paste BN. You can reach her at mjlee@usatoday.com and subscribe to our free Daily Money newsletter for personal finance tips and business news every Monday through Friday morning.