Friday, May 29, 2015

Tax savings strategies for recent retirees with substantial tax deferred retirement accounts

Now that the tax season is over, I want to highlight a few ways in which taxpayers with tax deferred retirement accounts between ages 59.5, when there is no longer an early distribution penalty, and age 70.5, when mandatory distributions come into play, may be able to save tax dollars by taking action before the end of the next tax year.

The first item I want to highlight is a situation in which the taxpayer has retired and during his or her working years has followed the advice of financial planners and saved substantial tax deferred dollars in a retirement plan. IRS rules require that these tax deferred savings be taxed according to the minimum required distribution (MRD) rules beginning at age 70.5. Often people retire early, or if not fully retired, work less than full time at reduced wages prior to fully retiring. They may have several years before they need to begin tapping into their retirement saving, as they are able to live on their Social Security and/or part-time employment earnings.

This situation may present an opportunity for some tax planning. As a tax preparer who not only prepares but also advises, I suggest that people take funds out of their tax deferred accounts before the mandatory requirement date, if they can do so in a lower tax bracket. I had one client this year who told me that he and his wife were able to live on their Social Security. He also made me aware that he had substantial tax deferred savings. He and his wife were both age 65 and had $40,000 of Social Security income. Because Social Security income does not start being taxable for those filing jointly until half of Social Security income plus other taxable income exceeds $32,000, he could have taken about $19,000 out of his tax deferred accounts and not paid any federal tax at all. Some state taxes would be due. Chances are if he waited until he was 70 and began taking his MRD, he would have to take out a higher amount, which would have made more of the Social Security taxable and as a result, he would pay more in federal taxes.

When I advised him to do this, his response was that he didn’t need the money, so why take it out? Taking it out does not mean you have to spend it. The tax laws allow people with tax deferred savings in an IRA account to convert those funds to a Roth IRA. He could convert the funds to a Roth, and in this case, take advantage of their tax bracket, save tax dollars and reinvest them the same way they had previously been invested. Once in a Roth, there are no MRD requirements for him and it offers some excellent estate planning features. The example I have given here is savings due to being in a zero tax bracket, but the same goes for being able to save by taking out when one is in the 10 percent or 15 percent bracket as opposed to what could potentially be a 25 percent bracket.

A second item I want to highlight is the fact that because Social Security income is taxable, one has to plan carefully if one needs funds for a major purchase or for an emergency and decides to take funds from a tax deferred account. Even when they have taxes withheld, taxpayers often face a large tax bill at tax time because they did not anticipate the fact that the distribution caused a substantial amount of their Social Security income to be taxed. If one requires funds and is in this situation, with a little foresight, one can borrow the funds through a home equity loan and may save substantial tax dollars.

A third situation encountered this year for the first time are taxpayers who took funds out of their tax deferred accounts and who also participated in the healthcare marketplace for health insurance and received an advanced premium tax credit as a subsidy toward the insurance. When they applied for the credit, they had not anticipated the extra income from their tax deferred distribution. This meant their income was higher than predicted and required them to repay part of the credit when taxes were filed. One of these clients was in a situation where he was able to mitigate the repayment substantially because he had some earned income, allowing him to reduce his taxable income by putting money into a traditional IRA, as this is permitted up until April 15 for the prior tax year.

This blog discusses three situations in which taxpayers who are in their early retirement years but prior to needing to take mandatory distributions from tax deferred funds can reduce their tax liability by doing advance planning. My advice is to use a tax preparer with a good understanding of tax law and be proactive in asking questions before deciding to take a distribution from a tax deferred account.