Risk & You 2011 - Special Report

Retired? Here's How to Cut Your Tax Bill

As many seniors learn, retirement can be as stressful and frustrating a time as any when it comes to paying taxes.

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With 401(k)s, traditional and Roth IRAs, as well as Social Security benefits and working wages, there's plenty to calculate on a tax return.

So, how can the retirement crowd cut down on their tax bills? Analysts say it starts with managing your money.

"Retirees usually have a bit more control over their tax situation than other taxpayers," says Steven Gershon, a director at the Kansas City, Kansas, office of the accounting and financial service firm, CBIZ MHM. "That's because they can decide how much they might need to withdraw from their retirement plans to keep their taxes low."

Delay, Delay, Delay

Most experts agree that delaying withdrawals from a 401(k) or traditional IRA until the age of 70 1/2 years is best for taxpayers — letting these plans grow tax deferred.

Taxes on withdrawals from these plans are eventually taxed at ordinary income rates — but that can increase by more than 10 percent if withdrawals occur before age 59 1/2.

This is where a Roth IRA can help, says Mike Scholz, tax director at Wegner CPA. Funds there can be withdrawn by age 59 when needed, tax free, if they've been open for at least five years.

"If a retiree doesn't have a current , it's worth it to see if a rollover from an existing IRA or employer plan to one makes sense," Scholz explains. "They have tax-free growth and tax-free distributions."

And having more than one type of IRA can help taxpayers when the required minimum distributions withdrawal, RMD, for these funds hits at age 70.

"RMD management is essential," says Lee Martinson, owner of PGA Financial. "Seniors have to know to take advantage of the aggregate rule, which says that withdrawals from one can satisfy withdrawals from all your vehicles. That will lower tax bills."

One other tactic to lower taxes is to shift taxable income around to different types of lesser- taxed investment vehicles.

"Some methods are very popular, like family limited partnerships, and things like trust life insurance annuities," says Alexey Bulankov, a financial planner at McCarthy Asset Management. "There are what's called Stretch IRA's to deal with estate taxes. Seniors should weigh the benefits of all."

Besides moving money, some retirees consider moving themselves to states like Nevada and Florida, that traditionally have low or no income taxes. But times have changed, says Gary Duboff, managing director of CBIZ MHM's New York City office.

"With the economic downturn, many states are enacting or thinking about new and higher taxes on residents," Duboff explains. "It's a common approach for many retirees to move, but unexpected changes in tax law could have an impact on planning."

Another problem for retirees on the move are gift and estate taxes. Many states — 21 to be exact — do not adopt the federal rules excluding up to $5 million of estate tax assets. That could cost retirees and their heirs additional taxes if they re-locate.

It's obvious, say experts, that retirees need to check out the tax laws of any new state they might want to move to.

A Dollar Earned ...

Social Securitychecks are welcome income for many retirees, but benefits are often taxed if a person has substantial additional income — such as wages, dividends, or interest.

No one pays federal income tax on more than 85 percent of benefits, but the combined income threshold — benefits and other income like wages — for when the tax kicks in is low: $44,000 for couples and as little as $25,000 for some individuals.

That means retirees ought to think about pushing back any extra income.

"Seniors should postpone taking discretionary income, like capital gains, to early January of a following year, instead of December, if they can," says Larry Karmel, a partner at the tax specialty firm, Metis Group.

"With the income threshold at 85 percent, delaying the income for a time makes the benefit dollar worth more than a dollar of other income," argues Karmel.

For married couples, itemized deductions also can help off set potential taxes on benefits, says Bulankov.

"Filing jointly may enable couples to deduct all or part of the long term care insurance premiums they pay for themselves if they meet certain IRS criteria—and help minimize benefit taxation," Bulankov explains.

Looking Ahead

If retirees find the tax burden heavy now, it could get heavier with tax reform.Some proposals include flat taxeswith the elimination of taxation on dividends and interest, but that could mean higher rates on wages.

Expiration of the Bush tax cuts — set for the end of 2012  — could raise rates on dividends from 15 to 39.6 percent — regular income that many seniors depend on. 

Meanwhile, taxes are going up in 2013. The health care bill passed in 2010 adds a 3.8% tax on wages above $200,000 for individuals on unearned income, including interest, dividends, capital gains and other investment income. And there will be a 0.9 percent increase in Medicare taxes on all wages for the same income levels.

With all that in mind, some tax analysts worry that retirees aren't prepared for their senior years.

"The cost of retirement has grown and many people have not saved enough," says Lee Isaccson, a CPA with the accounting firm, Reznick Group. "They need to budget their costs and understand that taxes are now part of their responsibility and start making estimated payments, where as an employee, they didn't have to."

In the end, experts say, cutting down a tax bill takes work.

"Plan ahead for taxes as much as planning for a vacation," says Mike Scholz. "A little tax planning now can produce enough tax savings to actually pay for a trip."