Thursday, July 23, 2015

The importance of tax planning for retirement


For most Americans, the two largest sources of income during retirement are Social Security benefits and retirement savings account, such as their 401(k) and Individual Retirement Account (IRA).
Most people are aware that withdrawals from a traditional IRA and 401(k) are fully taxable as normal income in the year these funds are distributed.
What may not be apparent is that there are special rules for determining if Social Security benefits are taxed, and by how much.
Under the tax rules, Social Security benefits will be subject to tax if the taxpayer’s provisional income exceeds certain income levels.
Provisional income, by definition, is the Adjusted Gross Income from the IRS Form 1040 plus nontaxable interest plus half of of Social Security Benefits. The end result determines whether there is no tax on the Social Security benefits, or if 50 percent or 85 percent of these benefits will be taxed. Under current tax law, 15 percent of Social Security benefits are tax free for everyone.
A taxpayer filing as single with a provisional income between $25,000 and $34,000, and married taxpayers filing jointly with a provisional income between $32,000 and $44,000 will pay taxes on 50 percent of their Social Security benefits.
A single taxpayer with provisional income over $34,000, and married taxpayers filing jointly with a provisional income over $44,000 will pay taxes on 85 percent of their Social Security benefits.
It should be noted that these income thresholds are not indexed for inflation and have been at these levels for many years.
So what is the problem?
If an individual is receiving both Social Security and income from a qualified retirement plan, he or she may be creating more tax liability than anticipated.
For example, if a single taxpayer withdraws just $2,000 monthly from his or her retirement plan in addition to Social Security, this taxpayer automatically causes 50 percent of their Social Security benefits to be taxed.
Married taxpayers filing taxes jointly have the same problem if they’re withdrawing about $2,500 monthly in addition to Social Security.
The more that’s withdrawn from a retirement plan, the higher likelihood of up to 85 percent of Social Security benefits being taxed.
For this reason, it is important for an individual or married couple to do some serious retirement and tax planning. With careful planning, it may be possible to significantly reduce or eliminate the taxation of Social Security, and perhaps even on retirement plan withdrawals.
Roth conversions
Re-characterizing IRA and other pre-tax retirement account funds to a Roth involves withdrawing these funds and re-depositing them into a Roth. The conversion requires paying taxes on the funds that are being re-characterized, so this wouldn’t necessarily be a step done in a single lump-sum, but rather gradually over time.
For this same reason, the taxpayer would not want to make this conversion the same tax year they were starting to receive Social Security benefits.
A second tax planning strategy involves postponing Social Security and subsequently “Spending Down” the IRA or other pre-tax retirement plan.
This strategy may be best suited for those individuals retiring early and who were considering drawing Social Security prior to their full retirement age (FRA), since any additional employment income prior to FRA could be penalized.
Spending down an IRA
Delaying Social Security can result in higher payments in the future, which could be advantageous to both the Social Security beneficiary and could have potentially higher benefits for his or her spouse.
The reduced retirement account balances could result in lower required minimum distributions after age 70 ½ as well, which could result in lower overall future income which would then include Social Security.
The drawbacks of this strategy include the fact that Social Security is only payable for the life of the beneficiary, whereas the retirement account values can be passed on to beneficiaries.
Should an individual not live long enough to realize the benefits of postponing Social Security, the overall result could be less overall income being passed to a surviving spouse or other beneficiary. Life insurance, however, could be built in as a replacement for these lost benefits in the event of a premature death.
Retirement planning has traditionally involved determining how much income would be needed at retirement, and creating a program of saving. The potential impact of taxes into this planning equation requires extra steps and consideration to be included in this process.
No taxpayer wants to pay more taxes than is necessary, and that is especially true in retirement when sources of income are limited.
We do not know what changes may take place with respect to the tax laws in the future. Every pre-retiree should build this tax planning into their retirement plans.
Speak with your tax professional and financial planning professional and create a plan for your retirement.

A little planning now may save you a lot of tax grief in the future.