Many people are focused on maximizing contributions and benefiting from compounding interest, but tax planning is a lesser-known afterthought when saving for retirement. For many retirees, most of their savings are in pre-tax accounts that are taxable during retirement. A failure to plan for taxes during retirement can have a large effect on your after-tax income, particularly when you fall into so-called tax traps.
In this article, we will look at the three biggest retirement tax traps and how you can plan ahead to avoid any problems down the road.
#1: Failing to Consider RMDs
The required minimum distribution – or RMD – is the minimum amount that you must withdraw from your retirement accounts each year. In general, you must start withdrawing money from an IRA, SEP IRA, SIMPLE IRA, or other retirement plan account when you reach the age of 70½. These withdrawals are included in your taxable income except for any part that was taxed before (your basis) or that can be received tax-free (qualified distributions).
The rules for calculating RMDs differs depending on a variety of factors. In general, the RMD is calculated by dividing the prior December 31 balance of the retirement plan by a life expectancy factor that the IRS publishes in Publication 590-B (see Table 1 below).
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Table 1 – Uniform Lifetime Table – Source: IRS Publication 590-B
There is a significant penalty for failing to withdraw an RMD by the deadline. If you fail to withdraw the full amount by the deadline, the amount that’s not withdrawn is subject to a 50% tax and the account owner must file Form 5329 with their federal tax return for the year in which the full amount of the RMD was not taken. The good news is that the penalty may be waived if the shortfall was due to reasonable error and steps have been taken to remedy it.
In addition to taking the RMD by the deadline, you may want to consider taking the first and second RMDs in separate years to avoid a large tax bill. For example, you may take the first distribution when you’re 70½ and then take the next distribution in the following year before the December 31 deadline. You may also want to space out these RMDs depending on the amount of money that you’ve made during a given year. Most of our clients divide their RMD by 12 and take them out as a monthly distribution throughout the entire year.
#2: Failing to Plan for Inheritance
Most people assume that a standard will covers all of their investments, but contrary to popular belief, named beneficiaries on retirement accounts may override a will. These accounts instead get transferred to heirs based on beneficiary designation forms that are filled out when opening an account. If these forms aren’t kept up-to-date, it’s easy for accounts to be transferred to ex-spouses or go into an estate where they’re liquidated at a high tax cost.
In addition to defining who gets the assets, beneficiary designations influence how quickly the funds must be withdrawn from the account. Most heirs would prefer to take required minimum distributions (RMDs) to minimize their tax exposure over time, enabling them to pay minimal taxes on the amounts over time. The need to take RMDs more quickly and lead to far higher tax rates and far less money than would be otherwise possible.
The best way to avoid these problems is to name a primary beneficiary (or beneficiaries) as well as an alternate beneficiary in case the primary beneficiary dies before you. Do not name your estate as the beneficiary since this has negative tax consequences. Trusts are another common IRA beneficiary mistake. Unless you ave specifically created a trust to receive the funds, it is normally advantageous to name a person(s) as your beneficiary. If you are divorced or married, update these forms, send them to the financial institution that holds the account, and ask them to acknowledge that they have received the request.
#3: Failing to Plan for Early Retirement
Many people aspire to retire early, but it requires careful planning to properly execute. If you take money out of a qualified retirement plan before 59½, you will likely pay a 10% penalty on the amount that you withdrew in addition to regular income taxes. You may want to consider setting up taxable accounts or using non-qualified retirement accounts to finance retirement between your early retirement age and 59½ years of age.
There are some notable exceptions to this rule to be aware of:
- Substantially Equal Periodic Payments (SEPP) – You may use the SEPP calculation to withdraw funds before the stipulated age as long as the amount is taken each year until the later of five years or reaching the age of 59 ½.
- Unreimbursed Medical Expenses – You may take distributions to pay for your unreimbursed medical expenses that exceed 10% of your adjusted gross income.
- Qualified Higher Education – You may take distributions to pay for higher education expenses for yourself, spouse, child, or grandchild.
- First-Time Home Purchases – You may take up to $10,000 in distributions to pay for a first-time home purchase (assuming no home ownership in the prior two years).
- Disability or Death – You may take distributions if you become disabled or if you pass away before the age of 59 ½.
In addition to these qualified distributions, you may initiate a one-time tax and penalty-free transfer from an IRA to a Health Savings Account (HSA). This was limited to $3,400 for self-only coverage and $6,750 for family coverage in 2017, plus a $1,000 catch-up contribution if you’re over the age of 55. HSAs may be used to cover qualified medical expenses during early retirement before Medicare and government assistance programs kick into effect.
The Bottom Line
Taxes play an important role in retirement and tax strategies should be carefully considered when planning for retirement. In particular, you should be aware of these three tax traps to avoid paying significant tax penalties without a good reason.