Tax season is in full swing, and by now your mail (or in) boxes have begun to be inundated with “IMPORTANT TAX DOCUMENTS ENCLOSED” correspondence.
For the newly retired, their first tax season after leaving the workforce may catch them a bit by surprise. They are used to receiving a paycheck from their company, and their employer usually helped them when it came withholding taxes from their earning (thanks to form W-4 elections).
Now in retirement, they have to create their own “paycheck,” consisting of a combination of Social Security benefits, pension income (for a lucky few) and/or retirement savings. Unfortunately in some cases, retirees may not be aware of the taxable impact each of these income sources has, nor realize that they are now responsible for calculating their own tax withholding needs.
To avoid surprises once retired, be sure to steer clear of these major tax mistakes.
1. Forgetting about taxes in the first place
Though there are a number of tax breaks Opens a New Window. available to seniors, many are shocked to learn that some, or most, of their income is taxable in retirement. Take Social Security, for example. Seniors without much additional income typically don't pay federal taxes on their benefits, but if you have a healthy amount of extra income coming your way, you might be taxed on your Social Security payments. To see whether you'll pay taxes on Social Security, you'll need to calculate what's known as your provisional income as follows:
- Take your total income outside of Social Security
- Add in any tax-free interest you receive (such as municipal bond interest)
- Add in 50% of your Social Security benefit amount
If your total falls between $25,000 and $34,000 as a single filer or between $32,000 and $44,000 as a joint filer, you could be taxed on up to 50% of your Social Security benefits. Furthermore, if your provisional income exceeds $34,000 as a single filer or $44,000 as a joint filer, you could be taxed on up to 85% of your benefits.
In addition to federal taxes on Social Security, these 13 states tax benefits to some degree:
- New Mexico
- North Dakota
- Rhode Island
- West Virginia
But it's not just Social Security income that's taxable in retirement. Unless you have a Roth retirement account, withdrawals from your IRA or 401(k) are also subject to taxes -- ordinary income taxes, in fact. If you fail to factor taxes into the equation when taking withdrawals, you could wind up with a hefty IRS bill. And if you don't have the money on hand to pay that bill, you may need to resort to withdrawing extra money from your retirement account to cover it and then paying additional taxes on that added withdrawal. Ouch.
To avoid this situation, plan to be taxed on your retirement income from the get-go and set aside money to pay whatever taxes you might end up owing. If you're not yet retired, another option is to open a Roth account or convert your non-Roth account into one. Roth withdrawals are always taken tax-free in retirement, and they're not subject to required minimum distributions, which, as you'll see next, can be another major tax trap for seniors.
2. Neglecting required minimum distributions
While required minimum distributions (RMDs) don't apply to Roth accounts, if you have a traditional IRA or 401(k), you'll need to start taking minimum withdrawals once you turn 70 1/2. The exact amount you'll need to take will be based on your account balance and life expectancy at the time, but if you fail to make that withdrawal, you'll lose out big time. Specifically, you'll be hit with a 50% tax penalty on whatever amount you neglect to remove from your account. So if your RMD for the year is $5,000 and you don't take it, you'll be kissing $2,500 goodbye.
It's important to pay attention to RMD deadlines so you don't get slapped with that penalty. Your initial RMD will need to be taken by April 1 of the year following the calendar year in which you turn 70 1/2. So if you turn 70 in May 2017 and 70 1/2 in November 2017, you'll need to take your first RMD by April 1, 2018. Following that initial withdrawal, you'll have until Dec. 31 of each calendar year to take your RMD.
3. Keeping sloppy healthcare spending records
Healthcare Opens a New Window. is a huge burden for retirees, and countless seniors spend a large chunk of their income on medical costs alone. But if you don't hang onto your records and receipts, you'll be doing yourself a major disservice. The reason is that if your out-of-pocket healthcare spending for the year exceeds 7.5% of your adjusted gross income (AGI), you're allowed to claim a medical expense deduction on your taxes (NOTE: tax year 2016 is the last year that seniors 65 and older may use this break in the medical deduction floor; starting in 2017 all medical deductions must exceed 10% of AGI). This means that if your AGI is $40,000, you can deduct any amount you spend above $3,000. So if your out-of-pocket costs total $6,000, you'll get a $3,000 deduction. Without proper documentation, however, you won't know how much to claim or whether you're eligible to take a deduction in the first place.
So save your receipts if you have medical deductions, such as:
- Prescriptions (but not over-the-counter medicine, except insulin)
- After-tax insurance premium payments (not premiums that reduced your taxable income already), includes premiums for Medicare Part B and Part D, or supplemental insurance premiums
- Costs for diagnosis, cure, mitigation, treatment or prevention of disease, or treatment that affects a function of your body, for which you were not reimbursed
- Lab services, including blood tests, x-rays, MRIs, and so on
- Travel and transportation for medical care, at 24 cents per mile. If you travel 20 miles round-trip to the doctor, for example, you can deduct $4.80, plus any parking or toll fees you paid. You also have the option of using your actual costs for gas and oil for medical transportation. If you have a major medical event that requires multiple trips, or travel to a facility farther from home, these expenses add up
- Disability accommodations. If you improve your home to accommodate a disabled person, you may be able to deduct everything from grab bars to wheelchair ramps
- Long-term care expenses. If you or a dependent received care in a facility primarily for medical care, the entire cost is deductible – even the portion that covers meals and lodging. It shouldn’t take long in one of these facility to meet and exceed your 7.5% or 10% floor for the year