In this article, we’ll discuss three tax surprises that often catch retirees off guard and how you can plan ahead to manage them. These topics are frequently overlooked in traditional advising, which is why we’ve built proactive strategies into our True North Method framework when working with clients.
Many people have well-thought-out retirement plans that allow them to live comfortably and often with a lower tax bill than during their working years. However, life happens, and circumstances can shift dramatically. Three things that commonly affect taxes in retirement are: required minimum distributions (RMDs), being single after losing a spouse, and inheriting large amounts of money. Each of these can lead to higher taxes, but with thoughtful planning, you can navigate these changes without being caught off guard.
Surprise #1 - Required Minimum Distributions (RMDs)
Successful retirees saved diligently and mastered the art of delayed gratification as it relates to building their nest egg. Sometimes, they’ve saved so well that they don’t need to withdraw significant amounts of income from their investments relative to the size of their portfolio(s). But the IRS has a plan to help these great savers spend these hard-earned dollars called required minimum distributions (RMDs).
What happens?
RMDs kick in when an individual reaches age 73, and age 75 for those born after 1960. These required withdrawals are considered ordinary income and can push you into a higher tax bracket. That extra income might also make more of your Social Security benefits taxable—up to 85%. On top of that, Medicare premiums might go up if you hit certain income thresholds called IRMAA surcharges.
What can you do?
One strategy is exploring Roth conversions before reaching RMD age. That way, you can pay taxes now while your rates are potentially lower and avoid some RMDs later. Another option is to give to charity directly from your IRA through a qualified charitable distribution (QCD), which can help lower your taxable income. (Read more about charitable giving from retirement accounts here.)
Surprise #2 - Single After a Spouse's Death
This one catches many people off guard. Unfortunately, death is a harsh reality, and those who are married may find themselves single for many years in retirement due to the death of a spouse. When your spouse passes away, your tax situation changes dramatically, often for the worse, and this is known as the “widow’s penalty.”
What happens?
For one, you lose the benefit of filing as a married couple, which means narrower tax brackets. The same income that was taxed at a lower rate when you were married might now push you into higher brackets. On top of that, if you inherit your spouse’s retirement accounts, the combined RMDs could increase your taxable income even further.
What can you do?
While both spouses are alive, it can help to withdraw more from retirement accounts or convert some to Roth IRAs. Doing this while filing jointly can soften the blow when only one of you is left to handle the taxes.
Surprise #3 - Inheriting Large Sums of Money
Although inheriting funds is a blessing, it can also potentially change your tax situation. If you or your heirs inherit significant assets, there are tax implications you need to be aware of -especially with retirement accounts.
What happens?
Under the newer law, most heirs must withdraw the full balance of an inherited IRA within 10 years. For high earners, this could mean a higher tax bill during their working years or even compound some of the issues mentioned above.
Additionally, if your estate exceeds the federal estate tax exemption, estate taxes could take a significant portion of the wealth you intended to leave behind.
What can you do?
Having proactive conversations with loved ones is key here. Strategies like gifting assets during your lifetime, setting up trusts, or incorporating charitable giving into your plan can help mitigate tax burdens for your heirs.
What’s the Big Takeaway?
Proactive planning is the key! The surprises mentioned above can drive a person’s taxes up for a long period of time and foil the best-laid plans. They may not happen to everyone, but it is important to look at your specific situation and consider the likelihood of each happening to you. These can be some of the driving factors that might make strategies like Roth conversions, charitable giving, or strategic withdrawals a crucial part of your planning.
Our advisors take pride in having these conversations with clients, and our True North Method ensures we bring these issues to light and address them appropriately. With the right process, we can help minimize some of these “tax surprises” and keep an eye to the future.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.
All investing involves risk, including loss of principal. No strategy assures success or protects against loss.
