Retirement Tax Traps to Avoid: Common Mistakes That Could Cost You

Retirement is a time when you should be able to enjoy the fruits of your labor, but navigating the tax landscape during retirement can be complex and full of potential pitfalls. If you're not careful, some common tax mistakes can significantly reduce your retirement income, leaving you with less to live on than expected.

In this blog, we’ll explore some of the most common tax traps retirees fall into and provide actionable strategies to avoid them, ensuring that you keep more of your hard-earned money.

1. Failing to Understand Required Minimum Distributions (RMDs)

One of the most significant tax traps for retirees comes from required minimum distributions (RMDs). Once you turn 73 (or 72, depending on your birth year), the IRS requires you to start withdrawing a minimum amount each year from your traditional IRAs, 401(k)s, and other tax-deferred retirement accounts. Failing to take your RMD on time results in hefty penalties — a 25% penalty on the amount not withdrawn (this penalty was recently reduced from 50%).

Why It’s a Trap: Many retirees either forget about their RMDs, don’t understand how they work, or don’t anticipate the tax hit these withdrawals can cause. RMDs are taxed as ordinary income, which can push you into a higher tax bracket and even cause your Social Security benefits to become taxable.

How to Avoid It:

• Plan ahead by understanding when RMDs start and how much you’ll need to withdraw. Most financial institutions provide calculators to help you determine your RMD.
• Consider taking smaller, strategic withdrawals from your tax-deferred accounts before reaching RMD age to reduce your future RMDs.
• For charitably inclined retirees, a qualified charitable distribution (QCD) can help. You can transfer up to $100,000 per year directly from your IRA to a qualified charity, satisfying your RMD requirement without triggering taxes.

2. Overlooking the Impact of Social Security Taxes

Another common retirement tax trap is failing to account for the taxation of Social Security benefits. As mentioned in a previous blog, if your combined income (adjusted gross income + nontaxable interest + 50% of your Social Security benefits) exceeds certain thresholds, up to 85% of your benefits could be taxable.

Why It’s a Trap: Many retirees assume that Social Security benefits are tax-free, but that’s not the case for higher-income retirees. Withdrawals from tax-deferred accounts and other income sources can push you over the limit, leading to unexpected taxes on your benefits.

How to Avoid It:

• Strategically manage your withdrawals from retirement accounts to control your taxable income and potentially reduce the portion of your Social Security benefits that are taxed.
• Draw income from Roth accounts, which don’t count toward your combined income, to keep your taxable income low.
• Time your retirement income streams wisely — deferring Social Security benefits can increase your monthly payments and may help you avoid taxation if done correctly.

3. Ignoring the Benefits of Roth Conversions

Many retirees neglect to consider converting traditional IRA or 401(k) funds into Roth IRAs during retirement. With a Roth IRA, you pay taxes upfront but enjoy tax-free withdrawals in the future, providing greater tax flexibility.

Why It’s a Trap: Failing to convert to a Roth IRA early in retirement can leave you with higher taxable income later when RMDs kick in. You may also miss out on the opportunity to lock in lower tax rates earlier in retirement when your income is typically lower.

How to Avoid It:

• Consider converting some of your tax-deferred retirement savings to a Roth IRA in years when your taxable income is relatively low. This allows you to spread out your tax liability and potentially reduce your future tax burden.
• Keep in mind that Roth conversions are subject to ordinary income taxes, so work with a financial advisor to determine the most tax-efficient timing and amount for conversions.
• The earlier you start planning for Roth conversions, the more flexibility you'll have in reducing future RMDs and taxable income.

4. Underestimating the Importance of State Taxes

State taxes can vary significantly, and some retirees move to tax-friendly states without fully understanding the potential impact on their tax situation. While federal tax laws are consistent, each state has its own rules regarding income taxes, including whether Social Security, pension income, or IRA distributions are taxed.

Why It’s a Trap: Retirees might move to a new state thinking they’ll save on taxes, only to discover that the state taxes a significant portion of their retirement income. Alternatively, staying in a high-tax state without proper planning can erode your retirement savings faster than expected.

How to Avoid It:

• Research the tax policies in your state of residence as well as any state you’re considering moving to. States like Florida, Texas, and Nevada don’t have state income taxes, while others may have exemptions for retirement income.
• Be aware of property taxes, sales taxes, and estate taxes, which can also vary significantly by state and affect your overall tax burden.
• Consider working with a tax professional to create a strategy that accounts for both federal and state taxes.

5. Not Factoring in Healthcare Costs and Medical Deductions

Healthcare expenses can be a major cost during retirement, and many retirees overlook the tax implications. While Medicare provides important coverage, there are still out-of-pocket expenses such as premiums, copays, and long-term care that can add up quickly.

Why It’s a Trap: Healthcare costs are often higher than expected, and retirees may not realize that these expenses can sometimes be deductible. For retirees who itemize their deductions, medical expenses exceeding 7.5% of their adjusted gross income (AGI) can be deducted.

How to Avoid It:

• Keep detailed records of your medical expenses, including premiums, prescriptions, and other out-of-pocket costs. You may be able to deduct a significant portion of these expenses if you itemize.
• Plan ahead for long-term care expenses, which can be particularly high in retirement. Long-term care insurance premiums are also deductible within certain limits.
• Consider using a health savings account (HSA) to pay for qualified medical expenses. If you have an HSA from your working years, withdrawals for qualified healthcare expenses in retirement are tax-free.

6. Forgetting About Capital Gains Taxes on Investments

Retirees who sell investments may face capital gains taxes, depending on how long they’ve held the investment and their overall income. Long-term capital gains are generally taxed at a lower rate than ordinary income, but this can still increase your tax liability if you’re not careful.

Why It’s a Trap: Large, unexpected capital gains can increase your taxable income, potentially pushing you into a higher tax bracket and increasing the taxation of your Social Security benefits. Additionally, many retirees sell investments without considering the timing or potential tax implications.

How to Avoid It:

• Be mindful of when you sell investments. If possible, spread out sales over multiple years to avoid a large spike in income in a single year.
• Utilize tax-loss harvesting to offset gains by selling investments that have lost value.
• Consider holding on to investments for more than a year to qualify for the lower long-term capital gains tax rates, which range from 0% to 20% depending on your income.

7. Overlooking the Importance of Estate Planning

Many retirees make the mistake of not updating their estate plan to account for tax-efficient wealth transfer. Without proper planning, your heirs could face significant tax liabilities on inherited assets, including retirement accounts.

Why It’s a Trap: Changes in tax laws, such as the elimination of the stretch IRA, have altered how inherited retirement accounts are taxed. Failing to update your estate plan can lead to unnecessary taxes for your beneficiaries.

How to Avoid It:

• Review and update your estate plan regularly, particularly if tax laws change or your financial situation shifts.
• Consider tax-efficient strategies for passing on assets, such as Roth conversions, charitable giving, and gifting.
• Work with an estate planning attorney or financial advisor to ensure your estate plan minimizes taxes for your heirs.