Six Retirement Tax Pitfalls

Jason Stipp: I'm Jason Stipp for Morningstar.

It's Tax Relief Week on Morningstar.com, and today, we're talking about managing taxes in retirement. A big part of that is avoiding retirement tax pitfalls.

Here with me to talk about that is Morningstar's Christine Benz, director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So Christine, you have six categories of potential pitfalls. The first one involves RMDs. These are "required minimum distributions" that you are compelled to take from certain types of retirement accounts. What's the pitfall here and how can you avoid it?

Benz: Well, the big pitfall is forgetting to take your RMD, because the tax penalty is very onerous; you will owe 50% of what you should have taken, but didn't. So, you definitely want to make sure you take that RMD.

A lot of seniors and retirees like to automate those RMDs. So, they have that money come right out of their IRA at the end of the year, so they don't miss the RMD. It also ensures that it's calculated correctly. So, you have to calculate the right amount.

Another thing, though, to think about rather than automating is to think about being strategic when taking RMDs. So, retirees may actually want to look at things that they wanted to sell anyway and think about taking their RMDs from those holdings, rather than taking a flat amount across all the IRAs, even ones that you like and want to hold.

Stipp: So second one, the second pitfall is related to RMDs somewhat, and it has to do with the order of withdrawal. So, it sounds like you have to take RMDs. But more broadly, as you are thinking about where you take money from, how can you avoid a pitfall here?

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Benz: Well, we've written a lot about asset location, and a corollary is sequencing your withdrawals. So, the name of the game with all of this stuff is stretching out the tax benefits of your tax-sheltered vehicles for as long as possible.

So, you do have to take those RMDs, but you can then turn to your taxable accounts to take the rest of your distribution or take what you need to fund your living expenses, and by holding as much as you can in those tax-sheltered vehicles--IRAs, Roth IRAs--you are preserving those tax-sheltering benefits for as long as possible.

So, the usual sequence of withdrawals is take your RMDs, then go taxable, then look at things that are traditionally taxed, so you'll pay tax when you withdraw. Then leave for last Roth IRAs because those will be most valuable to your heirs and those tax saving benefits can be stretched out the longest.

Stipp: Remember that the M in RMD stands for "minimum" you don't necessarily have to take all your living expenses from those accounts.

The next one, Christine, has to do with the income taxes. So before retirement, you are used to paying income taxes once a year; in retirement things tend to change. How can you avoid a pitfall in how you are managing your income taxes?

Benz: And another key difference, too, Jason is that you are not getting a paycheck in retirement, typically, although a lot of retirees are working these days. But if you are not getting a paycheck, that withholding isn't happening. So, you've got to pay the government, and they want you to pay as you go.

So, most retirees do pay quarterly estimated taxes. You want to keep these on schedule because if you are on the hook for these quarterly estimated taxes, you will pay a penalty if you don't pay them on time. So, keep these on your radar. There is a Form 1040-ES; that's an IRS form that includes a worksheet of how to calculate what your quarterly payment should be.

Stipp: Another thing, obviously, you will be thinking about as you are doing your taxes are the deductions you can take. Health care is one of those. How can you make sure that you are getting everything and not leaving any money on the table?

Benz: Well, a key thing to do is to keep very close track of what you are spending in terms of health-care expenses. So, these could be insurance premiums, long-term care premiums. A lot of seniors and retirees have very large pharmaceutical costs. So, make sure that you are tracking all these expenses, and then if they exceed 7.5% of your adjusted gross income in a given year, you can actually deduct that amount on your taxes. So, it pays to keep close track. I think a lot of retirees, unfortunately, will be surprised to see how large some of these expenditures are when they add them all up, but they could be valuable on their tax return.

Stipp: Another possible deduction has to do with real estate. How can you avoid pitfalls as you are doing your taxes and thinking about the possible deductions you can get for your homeownership?

Benz: A lot of the seniors I know and folks I talk to on the website, one of their biggest household expenses in retirement is their property tax bill, and they've maybe stayed in their large house where they raised their family because they love it and their kids love it, but it does trigger some very large taxes.

So in many states, there are exemptions, freezes, that you can apply for as a senior. In Illinois, for example, we've got a senior freeze for people who have incomes below a certain level. There may also be longtime homeowners' exemptions. So, even if your income isn't really low, you may still be able to qualify for something like that.

Then another thing: People who are lucky enough to have two homes may want to take a close look at that and think about--and, of course, there are lot of factors behind such a decision--but think about making their primary residence in the state where the property tax rates are the highest. That's a big decision, but maybe something to keep in the mix.

Stipp: Lastly, Christine, we have a very strong base of DIYers on morningstar.com; they like to do it themselves. But one potential pitfall, especially with taxes, is not asking for help when maybe help could really benefit you.

Benz: I think so. So, as you go along, certainly if you have something complicated going on with your taxes, it's great to find the partner, whether an accountant or a financial advisor. But I think this gets particularly important as folks get on in years. Maybe they have been very avid filers of their own tax returns. But I think it helps to loop someone in, in case something should happen to you.

Make sure that someone is abreast of your tax situation, knows where you keep your forms, keep your important documents. It doesn't have to be a professional; it could be maybe a trusted child, who also doesn't mind helping you out with this stuff. But I think going it alone, especially as you get very on in years, can be a mistake. It helps to enlist some kind of a partner.

Stipp: Great to have someone familiar with the situation, before they need to be familiar with it.

Benz: Exactly.

Stipp: Christine thanks so much for helping us avoid these retirement tax pitfalls.

Benz: Thank you, Jason.

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