When planning for expenses in retirement, it’s easy to focus on exciting things like travel and vacations while overlooking a significant cost: taxes. In a recent survey, 41% of retirees wished they had been better prepared for taxes leading up to retirement. Because tax laws change frequently and different types of income are subject to different treatments, proactive, strategic tax planning can save you thousands of dollars throughout retirement. Here are five things you need to know about taxes as you transition into retirement.

Tax Rates Aren’t Always Lower

Many retirees assume their expenses, including taxes and spending, will decrease once they leave the workforce, but this isn’t always the case. Although earned income will be lower, several factors affect the total tax owed.

First, retirees often lose key tax deductions available to employed individuals, such as the benefits of contributing to a 401(k) plan. Retirees enrolled in Medicare also lose the ability to contribute to a Health Savings Account (HSA), which offers a “triple tax advantage”. For those who relied on these deductions for years, finding replacements can be challenging.

Additionally, a significant source of retirement income comes from investment withdrawals, which are typically subject to capital gains taxes. Depending on your spending and other income, your tax rate could end up being similar to what it was when you were employed. Finally, having a paid-off home, while an accomplishment, means losing the ability to deduct mortgage interest. Given that tax rates are currently near historical lows and government spending is set to increase, tax increases are also likely.

Required Minimum Distributions (RMDs)

Addressing Required Minimum Distributions (RMDs) is an essential part of every retirement plan. RMDs begin at age 73 and apply to withdrawals from retirement accounts like Traditional IRAs and 401(k)s. They are calculated using a formula based on the account value and the owner’s age, and they typically increase annually.

• For those with multiple IRAs, RMDs are calculated for each IRA but can be withdrawn from any single account.
• For multiple 401(k) accounts, RMDs are calculated separately for each and must be withdrawn separately from each account.

Roth IRAs are funded with after-tax contributions and do not have RMDs. This allows the capital to remain invested, supporting growth for later retirement years. Furthermore, contributions can be withdrawn tax-free anytime, and investment growth can be withdrawn tax-free if the owner is 59½ and the account has been open for five years or longer. You can convert an existing IRA or 401(k) to a Roth IRA through a Roth conversion. Taxes would be owed on the converted amount, but the funds would then grow and be withdrawn tax-free (upon meeting requirements) and avoid RMDs. It is critical to find a balance between investing in different account types because each has unique advantages in your overall retirement income picture.

Taxes on Social Security and the Medicare Surtax

Depending on your provisional income, up to 85% of your Social Security income could be subject to federal income tax. Provisional income is calculated by taking the sum of your gross income, any tax-free interest received, and 50% of your Social Security benefits.

In addition to Social Security taxation, higher-income retirees may face the Medicare surtax. This is a surcharge on your Medicare Part B and Part D premiums that applies above certain income thresholds. Having the flexibility to incorporate tax-free sources of income can be hugely helpful in keeping your income below the level that triggers this surcharge. Incorporating tax-advantaged strategies like tax-loss harvesting can also help investors nearing those thresholds realize investment losses, potentially dropping them below the surcharge levels.

Taxes on Estates

In 2024, a federal estate tax is avoided if the estate’s value is less than $13.61 million for single filers or $27.22 million for those married filing jointly. However, this high limit is only temporary and is currently scheduled to drop to $5.5 million in 2026. Beyond federal taxes, the estate may still owe state taxes, which can be much lower than the federal rate. Given the likelihood of future changes to estate plans, it may be smart to explore gifting strategies, either to family or charitable institutions. Exploring the use of a trust can also be beneficial, as trusts are flexible and have the added benefit of avoiding probate.

The Standard Deduction Increases

The standard deduction has recently increased, making it an attractive option for people who may have typically itemized. For retirees, the standard deduction becomes even more attractive.

• In 2022, the standard deduction for those who are married and filing jointly was $25,900.
• If both spouses are over the age of 65, that amount increases by an additional $2,800.

Deciding whether to take the standard deduction comes down to running the numbers and determining if itemizing your deductions would provide a larger deduction.

The Takeaway

Taxes play a significant role in your overall retirement expenses and must be managed carefully to avoid overpaying. By knowing how different income types are taxed and what your available options are, you can start developing a strategy to keep the most money in your pocket.

If you are unsure how to approach tax planning, a financial advisor can help you run the numbers and build a tax-efficient retirement income strategy.

Would you like to know more about Roth conversions or how tax-loss harvesting works?