The Three Retirement Tax Landmines
You likely spent your working years with little control over your tax bill. If you were a W-2 employee, your salary determined the taxes you paid with some adjustments around the edges for things like retirement contributions, mortgage interest deductions, and charitable giving.
This more passive approach toward tax planning changes in retirement. The goal of effective tax planning is to pay what you owe, but no more than is necessary. Your retirement income plan must navigate the three major “Tax Landmines”:
Required Minimum Distributions (RMDs)
the Widow’s Penalty
Beneficiary Taxes.
1. Required Minimum Distributions (RMDs)
What are RMDs?
Required Minimum Distributions (RMDs) are mandatory withdrawals that retirees must take from their tax-deferred retirement accounts, such as traditional IRAs and 401(k)s, starting at age 73 (as of 2024, following changes in the SECURE Act 2.0). These withdrawals are subject to ordinary income tax.
Why are RMDs a potential tax landmine?
Each year after 73, the amount you will be required to distribute from these accounts increases. The increases start gradually, but by your late 70s/early 80s, RMDs can push you into higher tax brackets and trigger additional taxes on Social Security benefits and higher Medicare premiums. Depending on the amount of pre-tax retirement savings you have, failing to plan for RMDs may result in overpaying taxes by hundreds of thousands of dollars over your lifetime. Think about what you could do with that savings!
2. The Widow’s Penalty
What is the Widow’s Penalty?
The Widow's Penalty refers to the increase in tax liability that a surviving spouse faces after the death of their partner. When one spouse dies, the surviving spouse typically shifts from filing jointly to filing as a single taxpayer, resulting in higher tax rates on the same income.
Why is the Widow’s Penalty a tax landmine?
The transition from joint to single-filer status often means the surviving spouse will pay more taxes on the same or slightly reduced income. This can be especially burdensome because the survivor may still have significant RMDs and other income sources that will push them into still higher tax brackets.
3. Beneficiary Taxes
What are Beneficiary Taxes?
Beneficiary taxes refer to the taxes that heirs must pay on inherited retirement accounts. Under the SECURE Act of 2019, most non-spouse beneficiaries must withdraw all assets from inherited IRAs within 10 years of the account holder’s death. These withdrawals are subject to ordinary income tax.
Why are beneficiary taxes a tax landmine?
The 10-year rule can force beneficiaries to take large distributions over a relatively short period, potentially during their peak earning years. This can significantly increase their taxable income, pushing them into higher tax brackets and creating a substantial tax burden.
Note that this is a different topic than estate taxes, which are only a concern for the wealthiest families because of the high exemption amount. Currently, estate tax kicks in for individual estates larger than $13.6 million, which is effectively doubled for married couples. However, the exemption amounts are set to be cut in half when the TCJA expires in 2026 unless Congress extends them.
What can be done to avoid the retirement tax landmines?
Income smoothing: The goal of retirement income tax planning is often to smooth out your income over your lifetime rather than minimizing taxes in any given year. If you have multiple types of savings (pre-tax, taxable, and Roth) you have a great deal of control over your tax bill, particularly before RMDs kick in. If you are trying to minimize taxes early on, you could be setting yourself up to significantly overpay taxes over your lifetime.
Roth Conversions: Converting traditional IRA assets to a Roth IRA can reduce the balance subject to future RMDs and smooth out your income. Roth IRAs are not subject to RMDs during the account holder's lifetime, and qualified withdrawals are tax-free. Large Roth conversions early in your retirement can help with all three tax landmines by reducing RMDs for your surviving spouse and taxes owed by beneficiaries of your retirement accounts. Beneficiaries of a Roth account will not pay taxes either and currently have 10 years to make distributions, during which time the Roth accounts can continue to grow tax-free.
Qualified Charitable Distributions: Retirees aged 70½ or older can donate up to $100,000 annually directly from their IRA to a qualified charity. This amount counts toward the RMD but is not included in taxable income. If you regularly give to your church, synagogue, or other charitable organizations (or are inclined to start!), then planning to fund your gifts with QCDs is a win-win.
Estate planning: Proper estate planning, including setting up trusts and beneficiary designations, can help manage income and tax burdens for the surviving spouse and heirs. Your plan can involve strategies like leaving retirement accounts to younger beneficiaries who might be in lower tax brackets or using trusts to manage the distribution timeline and tax impact.
Charitable Bequests: planning to leave pre-tax retirement assets to charitable organizations can eliminate the tax burden on heirs, as charities do not pay taxes on these assets. This can be part of a broader estate planning strategy to balance charitable intentions with tax efficiency.
Life insurance: A life insurance policy can provide a tax-free death benefit that helps cover increased tax liabilities and living expenses for the surviving spouse. Generally, life insurance is far less necessary once you are retirement-aged, but it can be an effective tool for some situations, including larger and less liquid estates (i.e. above the ~$13 million estate tax exemption) or as part of a hybrid long-term care policy.
Working with a financial advisor who specializes in retirement planning can provide personalized strategies to navigate these complex tax issues effectively. With proactive planning, retirees can mitigate the impact of these tax landmines and enjoy a more financially secure and less stressful retirement.