Top Six Tax Tips for Retirees

Jason Stipp: I'm Jason Stipp for Morningstar. It's Tax-Wise Investing Week on Morningstar.com, and today we're talking about tax planning in your portfolio, specifically retirement tax tips.

Joining me is Morningstar's Christine Benz, director of personal finance.

Thanks for being here, Christine.

Christine Benz: Jason, great to be here.

Stipp: So you have a few tax tips for folks who are in retirement. We know this is a great proportion of our audience out there. I want to start with one that can really be a bit of a tangled mess to try to unwind, and that's the sequence of withdrawals. This is obviously a very important thing for retirees. It has a lot of tax implications too, though.

Benz: It does, and I think a good overarching principle, even though it is very complicated, is thinking about which of your accounts is the most costly to you on a year-to-year basis. So the starting point for sequencing your withdrawals is if you are age 70 1/2, and you are required to take minimum distributions from your IRAs and 401(k)s, you've got to take those, otherwise you will pay tax and a big penalty equal to 50% of what you should have taken but did not. So, RMDs are mandatory. That should be a starting point for anyone who has hit that age threshold.

Next in line would be taxable accounts, because from year-to-year you may pay income and capital gains taxes on the investments that you hold in them. So, you want to loot them next in line.

And then next would be any traditional 401(k)s or traditional IRAs, where you're not paying taxes year-to-year, but you are having to pay taxes on your withdrawals, and the last thing you want to hang on to is any Roth assets--Roth IRAs or Roth 401(k)s--but especially for people right now most people have Roth IRAs as opposed to Roth 401(k)s. You want to save those the longest because the benefits to your heirs are the greatest, and also you do not have to take RMDs from those accounts.

So, if you do want to pass them to your children and grandchildren, you'll be able to do so, because you're not forced to tap them while you're in retirement.

Stipp: So, tap the mostly costly first; on the flip side, [those accounts] where you have the biggest benefits, you want to hold on to that as long as you possibly can and extend those benefits.

Benz: Exactly.

Stipp: It seems like this would also have some implications about what kind of assets you hold in these different kinds of accounts, right?

Benz: It does, and so I think the key thing you want to keep in mind is if you are tapping accounts for living expenses, you want to make sure that you at least have some very liquid assets, so you are not having to liquidate positions to take distribution. So, I think that, at a baseline, is something that you want to be sure of.

Stipp: Christine, number two tax tip for retirees--this is an area of the market, the municipal bond area of the market--that has been of different levels of concern recently. We saw it really spike a little while ago, when people were worried about bankruptcies. It seems to have gotten a little bit better since then. But I think it's still something that maybe some investors throw their hands up and say, "I'm not even going to think about munis." But that might be a mistake.

Benz: Well, some investors might say, "I'm not in super-high tax bracket, so they probably don't make sense for me."

And I would say, revisit that assumption, and one way to do that is on our website, we've got a bond calculator that has a tab that lets you compare the yields of taxable bonds or bond funds versus municipal bonds, and you're able to plug in your own state tax rate, your federal income tax rate, a couple of other variables, and you can see how does that muni's yield compare to a taxable bond's once the tax effects have been factored in.

You may be surprised at what you see. In talking to our colleagues who cover municipal bond funds, they still think that the area is relatively attractive, even given the strong runup we saw in 2011.

Stipp: So, it could be even if you're not at the tip top of those tax brackets, it could be an area worth considering?

Benz: Exactly.

Stipp: You mentioned these in number one, RMDs. There are a lot of things to remember about RMDs--certainly some pitfalls there. When you're thinking about the tax tips you want to express about RMDs, what's top of mind?

Benz: Well, first take them. So, we talked about the penalties and taxes you'll face if you do not take them.

Also think about automating them, so check in with your financial-service provider. Most of them will be able to just cut you that check toward year-end, so you don't risk missing one of these distributions.

Another point I would make, Jason, is that even though you do face these onerous penalties if you miss those distributions, plead your case with the IRS or write a letter, do whatever you need to do, because the IRS says that if the omission is due to reasonable error, that the penalty will be waived. So, that's another important thing to keep in mind.

One last point on RMDs: We've been talking a lot about withdrawal rates with users on the site. A lot of users have been weighing in with really great comments, and one point I would make is that people have said, "Well, RMDs are causing me to increase my withdrawal rate beyond that 4% or whatever I had originally calibrated." The point is, you do not have to spend your RMDs. Just because you're required to take some money out of your traditional 401(k)s and IRAs, that doesn't mean you have to spend it. You can go ahead and just plow it into your taxable accounts if you don't need the money in that year.

Stipp: So, Christine the fourth tip actually is related to that, and that has to do with the notion that folks, I think, enter into this drawdown period, but that doesn’t mean that when you are in retirement that you can’t continue to save for retirement. Retirement could be a 30 year process or longer. But what do you need to keep in mind about your retirement savings as you get into those retirement years?

Benz: So the one big benefit, or one of the many benefits, with Roth IRAs is that you can continue to contribute to them, there is no age limit on additional contributions. The key thing you need to keep in mind is that you do have to have earned income to be able to make a Roth IRA contribution. So you want to make sure that you have earned income at least equivalent to the amount you hope to contribute to make that contribution. That may be another reason to think about having a part-time job in retirement.

Stipp: We've spoken a lot about all the benefits that can accrue by working a little bit into retirement that could be another important benefit there.

The fifth tax tip involves property taxes. We know a lot of retirees probably own their homes outright, but property taxes are one of those variables they still must manage. What should they keep in mind there?

Benz: Right, and they can be a big share of their household's expenses. I think the key thing to keep in mind is check in with your municipality and see what kind of tax breaks are available to seniors. There may be freezes for seniors with income below a certain threshold. There may be longtime homeowners exemptions. And these freezes and exemptions do vary by municipality, so check in and see what kind of break your municipality offers to seniors.

Stipp: And lastly, Christine, another big household expense: medical expenses. You can also have some tax benefits from these expenses. What do you need to know there?

Benz: So the key thing to keep in mind is that you want to track them, because if they do exceed 7.5% of your adjusted gross income, you are able to take a deduction on that amount over 7.5% of your AGI. So keep tabs on prescription costs; certainly any doctor's bills or insurance premiums would all be deductible. See if they are getting close to exceeding that 7.5% threshold.

On the flip side, though, I think people need to keep in mind that their itemized deductions, especially when they are in retirement, may not be as great as the standard reduction. They may be better off just taking the standard deduction versus itemizing, and one big deductible amount that often isn’t there for retirees is the mortgage interest exemption. So just run the numbers, make sure that itemizing, even though it made sense for you while you were in your working years, it might not make sense anymore.

Stipp: Christine, a lot of tax considerations in retirement, but thanks for bringing some of the top considerations to us today.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp, thanks for watching.