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5 Tax-Planning Tips for Retirees

Jason Stipp
Christine Benz

Jason Stipp: I am Jason Stipp for Morningstar. Retirement is supposed to be a time that you can step away from a lot of the day-to-day hassles of life, but unfortunately tax planning is not one of those things. Here to offer some top tips for retirees on the tax front is Morningstar's Christine Benz, our director of personal finance. Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: There are a few more complications that come into play when you go into that drawdown mode or retirement mode on the tax front. The first one is about withdrawals, so you will be taking money out of your portfolio. There can be some big tax implications here. What should investors keep in mind?

Benz: Well, I think that one of the key concepts to keep in mind is that there are some sensible sequences of withdrawals that will tend to make sense for retirees with a lot of different profiles. So, definitely you want to make sure you're taking your required minimum distributions from your traditional IRAs or 401(k)s.

Then probably in most cases move to the taxable accounts for the next set of distributions. Then [tap assets from] traditional IRAs and 401(k)s. And save those Roth assets--to the extent that you have any in your retirement plan--to the very last. The key idea across all of these different categories is that you want to save the accounts that have the most tax advantages until the last, while getting rid of those with the least tax advantages--or the heaviest tax costs from year to year--getting rid of those first.

Stipp: And even that first bucket Christine--those RMDs that if you're over age 70 1/2, you do need to take those, otherwise you face penalties--you say you don't have to always take them though from the same account. You could have some flexibility there?

Benz: You absolutely do. I think sometimes people think, well, I need to take proportionate shares out of every holding in this account. You can actually be quite strategic about where you go for the RMDs. So, for example, if you have a holding or two and they're at a low ebb--maybe the market is down and you think they'll recover--you can leave those alone and instead pull money from something that you think is maybe overpriced or something that's more liquid. So, you can definitely be strategic, and you should think about that when RMD season rolls around. As long as you're pulling money from the right account type, you can be fairly discretionary in terms of where you go for that cash.

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Stipp:  A second tax tip for retirees, Christine, you say that, although a lot of folks go into drawdown mode and they're taking money out of their portfolio, it doesn't mean that you can't still also invest?

Benz: That's right. So, some people assume that while I'm taking RMDs, I have to spend that money; you can actually reinvest RMD proceeds that you don't need. And if you have earned income or if your spouse has enough earned income to cover your contribution amount, you can actually move that money into a Roth IRA where there are no [age] limits on contributions. So, it's definitely something to keep in mind, especially sometimes people say, "Well, my RMD amount is taking me over the withdrawal amount that I had wanted to stick with. I had wanted to stick with 4% and the RMD is going to put me at 6%."

Well, you can go ahead and reinvest that money in a Roth if you can or certainly in a taxable account.

Stipp: The third tip for retirees is that a lot of attention is paid to federal tax rates, but you say it's also important to look at your local tax rates, your municipal tax rates, and some of the tax breaks that you could get there, as well?

Benz: That's absolutely right. And ideally this is something that you'd give some thought to before you decide where you will retire because people can really move the needle in terms of their living expenses by paying attention to the state and local, the municipal taxes that they pay. So, you'd want to think about this if you're thinking about a relocation decision, there are some nice tools out there on the Web to help you look at income taxes and other taxes at the state and municipal level.

And if you are living in your home, I think it's very important to keep in mind that there might be some property tax deductions or reductions that you can obtain if you are a senior. So there might be a long-time homeowners' exemption. And if your income falls below a certain level, many municipalities offer a freeze for people in that situation, so definitely investigate.

Another lever that people have is that they're able to appeal their property taxes if they feel that they are high relative to comparable properties in their area. So, definitely look at all those maneuvers because those property tax bills can be a very high share of many seniors' living expenses.

Stipp: Another thing, and your fourth tip, that is a big share of a lot of expenses for retirees is health care. What should investors in retirement think about on the tax front with health care?

Benz: Well, just bear in mind [that for the 2012 tax year] you can deduct your health-care-related expenditures that are over 7.5% of your adjusted gross income. That sounds like a big number, but really when you total all of the various premiums that you're paying, such as health-care premiums, long-term care insurance premiums, perhaps out-of-pocket prescription drug costs, all of those things if you carefully tally them, you may find that you're well over that 7.5% threshold. So, just saving all those receipts and totaling them up each year can be a really valuable exercise.

Stipp: A fifth tip for retirees is on estate planning. There was a lot of uncertainty about the estate tax recently; some of that has been settled and made more certain, but folks might have put off their estate plan. Your tip is, don't forget about estate planning.

Benz: No, [don't forget about estate planning]. And another related point is that the estate tax-exclusion amount is over $5 million currently. So, I think a lot of people, whether seniors or people who are still working might think, "Well, I do not need to worry about estate taxes, so why do I need to worry about estate planning?"

And the key thing to keep in mind is that estate planning encompasses so much more than tax planning, so that means: Do you have your executors named? Are your beneficiary designations up to snuff with where your current life stage is? Have you named powers of attorney for health-care and financial considerations? And finally, do you have a living will? All of those things fall under the estate-planning umbrella. Even if you're nowhere close to the exclusion amounts, it's still worth making sure that you're not completely neglecting this whole set of other very important decisions.

Stipp: Getting your tax plan in order, is an important component of a secure retirement. Thanks for offering those tips today, Christine.

Benz: Thank you, Jason.

Stipp: For Morningstar, I am Jason Stipp. Thanks for watching.

See More Articles by Christine Benz

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