Ah, the holidays. The festive time for family gatherings, great food, a little sparkle… and year end tax advice. As if the season wasn’t hectic enough, this is the time you need to make sure that you do everything you can to minimize your tax burden.
1. First and Foremost, Don’t Overlook Required Minimum Distributions (RMDs)!
This is perhaps the easiest piece of year end tax advice for retirees:
Don’t forget to take your RMDs!
However, Fidelity Investments reports that the majority — 61% — of their account holders who are older than 70 1/2 have not yet taken their Required Minimum Deductions (RMDs). What?!? Get to it!
If you’re 70 1/2 or older and have a traditional IRA, the IRS requires you to take a certain minimum amount from your account each year – and if you don’t take enough, you’ll be slapped with a huge tax penalty. Tax-deferred retirement savings accounts such as traditional IRAs and 401(k)s give you a handsome tax break right up front: the money you contribute to these accounts is deducted from your taxable income. Unfortunately, the IRS’s generosity has limits.
When you take money out of your tax-deferred IRA or 401(k), you have to pay taxes on those distributions. If you were to simply leave the funds in your account forever, perhaps bequeathing it to one of your children, then the government might have to wait indefinitely before it sees a penny of taxes on that money. That’s why the IRS instituted a rule that once you reach age 70 1/2, you must start taking distributions. Your RMD for the year is based on your age and on the balances of your tax-deferred accounts. As you age, you must withdraw a larger proportion of the remaining balances, so amounts may go up or down year to year.
Calculating Your RMD
The NewRetirement retirement planning calculator automatically accounts for RMDs for all of your wealth projections. Starting at age 70.5, the calculator estimates required minimum distributions based on IRS Publication 590-B. Excess withdrawals not used to cover monthly expenses are assumed to be added to your “Other Savings.”
However, you need to really do it in real life — every year! The IRS provides two worksheets to help you calculate your required minimum distributions. Most retirees will use the default RMD worksheet; if your spouse is the sole beneficiary on your IRA and he or she is more than 10 years younger than you are, use this RMD worksheet instead.
In order to calculate your RMDs for the year, you’ll need to know the balances on all your traditional IRAs as of December 31 of the previous year. You can find this information on your IRA provider’s end of year statement; if you no longer have that document, call the IRA provider and ask for another copy. Note that you shouldn’t include the balances for any Roth IRAs in this total; Roth accounts are exempt from RMDs. Once you’ve found all your IRA balances from the end of last year, add them up and write down the total on line one of your RMD worksheet.
If you’re using the default worksheet, you’ll need to look at the table at the bottom of the worksheet and find your “distribution period,” which is the IRS actuary’s estimate for how long your retirement will be. Find your age on the table, then write the number from the distribution period column on line two of the worksheet.
If you’re using the younger-spouse worksheet instead, you’ll use a different table to find your distribution period: one that combines your age and your spouse’s age. Find your spouse’s age in the first row on Table II, then find your age in the column on the far left side of the table. The box where your age and your spouse’s age intersect is the number to use for line four of the RMD worksheet. You may have to scroll down quite a bit, as Table II is very long and is in separate parts.
Finally, divide your total IRA balance by the distribution period number and the result is your required minimum distribution for the year. For example, if you had $800,000 in your traditional IRAs on December 31 of last year and the distribution period for your age is 26.5, your RMD for the year would be $30,188.68. If you have more than one traditional IRA, you can divide the minimum distribution out over your IRAs as you prefer. For example, you could take it all from one IRA, split it up evenly between your IRAs, and so on.
The Problem with Required Minimum Distributions: But what if you don’t need $30,188.68 this year? Too bad – you still have to take at least that much in distributions or pay a penalty of 50% of the amount you failed to take. If the retiree in the above example only took $20,188.68, then he’d owe a penalty of 50% of the $10,000 he didn’t take, or $5,000.
Unfortunately, even if you do take the correct RMD, you’ll still have a tax penalty of sorts – you have to pay income taxes on the entire distribution. That’s why it’s important for retirees to do what they can to reduce their overall tax burden – doing so helps you to counteract the extra income taxes your RMDs may generate.
2. Cut Your Taxable Income
The most basic and powerful way to cut your taxes is to cut your taxable income. You can do so in a number of ways: find sources of nontaxable income, use deductions to remove income from your taxable total, grab any tax credits you qualify for, and so on. Here are a few specific examples.
Do a Roth Conversion
If you didn’t contribute to a Roth account during your working years, it’s not too late – you can take some of the money from your traditional IRA and put it in a Roth IRA instead. Not only does that turn the money you moved into nontaxable income, but it also helps to reduce your RMDs by lowering the balances in your traditional IRAs.
However, there’s one big catch: when you do a Roth conversion, you have to pay taxes that year on the money you moved to the Roth account. If you have a huge balance to convert, you may not be able to afford to do it all in a single year. For example, if you’re single and you decide to shift $500,000 from your traditional IRA into a Roth IRA, doing the entire conversion in one year would put you into the top income tax bracket and would generate a $153,818.85 tax bill on that money alone!
On the other hand, splitting the conversion out over five years would reduce your annual tax bill for the converted money to $20,971.75 and would reduce the total tax bill for the conversion to $104,858.75. And if you spread the conversion over 10 years instead, you’d cut your annual tax bill on the converted money to $8,238.75 and would reduce the total tax bill for the conversion to $82,387.50, a mere 16.5% of the balance (note that all of these examples are based on the 2017 income tax brackets; changes to the tax brackets for future years may alter your results).
Try Tax Loss Harvesting
If you sell investments that aren’t tucked away in a tax-advantaged retirement account, you’ll have to pay capital gains taxes on the profits you made from those investments. However, if you sold any investments at a loss during the same year, you can wipe out those gains for tax purposes and avoid paying the related taxes. This approach is known as tax loss harvesting, and it allows you to get rid of your loser investments while profiting a little from the transaction. In fact, if you have more losses than gains, you can use the extra losses to erase up to $3,000 of other taxable income (including the distributions from your traditional IRAs).
Max Out Medical Expenses
If you’ve already had some significant healthcare expenses for the year, see if you can move medical expenses that you’d normally take next year to the end of this one. For example, if you have a dentist appointment in January, move it to mid-December instead. By grouping as many medical expenses as possible in a single year, you can maximize the deduction you get for those expenses. This is a particularly wise move for 2017, since tax reform may eliminate the medical expense deduction in the near future. If that happens, you’ll be glad you maxed out the deduction this year.
Give to Charity
Taking the medical expense deduction requires you to itemize rather than using the standard deduction, so it’s best to pile on as many other itemized deductions as you can. The charitable donation deduction is a great place to start, since you can earn yourself a significant deduction without spending a dime. Just go through your closets and your attic, pull out all the stuff you’re no longer using, and donate it to Goodwill or the Salvation Army. You can claim a deduction for the value of the goods you donated, up to a maximum of 50% of your adjusted gross income for the year.
3. Other Year End Tax Advice for Retirees
Here are a few other pieces of year end tax advice for retirees…
Thinking of Relocating in 2018? Consider the Best States to Retire in for Taxes!
Most of the wisdom shared above is most relevant to federal taxes. However, state taxes can take a big bite out of your retirement nest egg as well.
If you are considering relocating for retirement, you might as well look at states that have the most favorable tax rates for retirees. These 10 locations are the best states to retire in for taxes.
Consider Getting Professional Help
When you’ve got a lot of financial balls in the air, your tax return can get remarkably complicated. This is especially true if it’s the first year you’re taking a required minimum distribution. In that case, strongly consider getting a tax pro (a CPA or enrolled agent, not an uncertified tax preparer) to do your return for you.
Not only will you know that you’re getting every possible tax break, but you can even deduct the tax preparation fees from your next year’s return!
A certified financial advisor is another great resource for year end tax advice! Look for one that specializes in retirement planning.
Keep an Eye on Tax Reform!
Your guess is as good as mine about whether or not tax reform will pass this year. However, it is certainly worth keeping an eye on it and consulting a tax professional if it passes to see if there is anything you can do this year to minimize your tax burden in the future.
Let us help you figure some of this out.
See how RMDs and tax optimizations impact your retirement plan.
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