Approximately 10,000 people will reach retirement age each day for the next 20 years.
This huge wave of baby boomer retirees need to start thinking about tax planning as taxes are the single biggest opportunity as well as threat facing their retirement plans.
Taxes as a retiree can be confusing. That's why competent tax preparation combined with diligent tax planning is key for retirees enabling them to keep more of their money and reduce their stress. Here are some important things all retirees should know.
What to Do with Your 401(K)
A big part of retirement tax planning is about knowing what to do with the savings you've accumulated in your 401(K).
If you have a balance of over $5,000, most employers will allow you to keep it right where it is. If they offer you low fees and if you like the investment choices, it may be a good idea to keep your savings there. However, most 401(k) and 403(b) plans offer less investment options with higher costs, making a rollover a potentially better option (see next section).
If you are over 55 years old when you retire, you can start tapping your 401(K) without penalties. Keep in mind that you will still owe income taxes on any withdrawals. There are some caveats with doing this so consult with your tax advisor.
Rollover to a Traditional IRA
If you want, you can roll your funds into an Individual Retirement Account (IRA). This gives you more investment choices, but you must be at least 59½ years old to avoid early withdrawal penalties.
By rolling over into an IRA, you can preserve your tax deferral by transferring the funds directly to a broker or mutual fund company.
Be careful to avoid having the check made to your name. If you do this, your employer has to withhold 20% for federal taxes which you have to come up with yourself and deposit into the IRA account.
There's also a 10% federal penalty if you don't get your funds into the IRA before 60 days after withdrawal.
Avoid this headache by having your retirement plan send the money directly to your IRA.
What About Social Security?
After retirement, you also need to consider social security as part of your tax preparation.
You can start taking your Social Security benefits as early as 62, but your retirement benefits will be decreased by 25% or more for the rest of your life.
If you wait until you reach full retirement age, (age 67 for those born after 1960) you will get your full benefits.
Waiting until age 70 means you qualify for a larger retirement benefit.
Think about whether you plan to keep working once you start collecting your benefits. If you are younger than the standard retirement age, you will lose $1 in retirement benefits for every $2 you earn over the earnings cap. In 2019, the earning cap is $17,640.
Tax on Social Security
Understanding tax deductions on Social Security will have a big impact on your future tax preparation.
Whether or not any of your benefits will be taxed depends on your Adjusted Gross Income.
If your income is less than $25,000 on a single return or $32,000 on a joint return, your Social Security benefits are tax-free.
If your income is between $25,000 and $34,000 you will pay tax on up to 50% of your benefits.
Incomes over $34,000 are subject to pay income tax on up to 85% of their benefits.
It's up to you if you want taxes to be withheld from your benefits each month. This may help you avoid making quarterly estimated tax payments.
Keep in mind that state tax laws vary. Some states exempt some or all of your Social Security benefits from income taxes.
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Keep Track of Medical Expenses
The standard deduction for medical expenses is higher than it used to be in the past. Most people won't be able to take an itemized deduction for medical expenses now unless they have significant medical expenses (over $12,200 for individuals and $24,400 for married couples in 2019).
Yet, it's still important to keep a record of your medical expenses. That way, if you suddenly have high medical bills, you can have your documentation for the tax year ready.
Don't forget to include hearing aids, lab tests, prescriptions, prescription eyeglasses, medical equipment and premiums for Medicare Parts B, C & D, as part of your medical expenses.
Possible Credit for Those Caring for an Aging Parent
If you are retired and are a caregiver for an elderly parent, you might be able to claim a $500 tax credit. There are certain criteria in order to be eligible. Yet, it is something not to overlook during the tax preparation season.
Gifts and Charitable Donations
Many retirees donate to charity and give money to family members.
While gifts to family are not tax deductible, the IRS allows you to give $15,000 annually to a family member without needing to worry about federal gift taxes. If you give more than that, you must file Form 709, disclosing the gift.
If you like to contribute to charity, there is a better way. By donating through the Qualified Charitable Distribution program, your donation is sent directly from their IRA and paid to the charitable organization. This method does not make the donation taxable income.
You can also consider utilizing a Donor Advised Fund in order to group your expenses in any given year, utilizing itemizing one year and taking the standard deduction the next.
Final Word on Tax Preparation for Retirees
As you can see, as a retiree, it’s vital that you understand all the tax implications of your choices. After all, you've worked hard for many years and you should get the most out of your hard-earned dollars.
At PJF Tax, we can help you navigate your retirement. With the right tax preparation, we can make sure more of your money stays with you and your loved ones.
Contact us to get started.
Please note all the numbers used in this article are from 2019 and may adjust every year. Please check with the IRS for updated numbers.