Entering the phase of retirement brings with it relaxation and the opportunity to pursue adventures. After years of dedicated work, retirees eagerly anticipate reaping the rewards of their life’s labor. However, amidst the prospect of leisurely days, there lurks a big challenge: navigating the world of taxes.
As retirees step into this new chapter of life, they may unexpectedly find themselves entangled in a complex labyrinth of tax laws and regulations. Navigating through this labyrinth can be a daunting task, as even the smallest misstep could prove to be financially burdensome, threatening to deplete the hard-earned savings they’ve diligently accumulated over the years.
Here are 7 most common tax mistakes in retirement.
1. Forgetting health care expenses and deductions
Retirement brings with it a unique set of financial considerations, and one of the most significant among them is the potential for substantial healthcare expenses. As individuals and couples transition into their golden years, it becomes increasingly crucial to plan for the financial burden that medical costs can impose.
According to Fidelity, the average retired couple at the age of 65 may require a sizable sum of approximately $315,000 saved after taxes specifically to cover medical expenses throughout their retirement journey.
It’s important to note that there are avenues for mitigating these expenses through tax deductions. Some medical and dental costs can be deducted, offering a valuable opportunity to alleviate the financial strain. The Internal Revenue Service (IRS) allows individuals to deduct eligible medical and dental expenses that exceed 7.5% of their adjusted gross income.
Moreover, for individuals who travel to receive necessary medical treatment, there’s an additional deduction available. The IRS permits a deduction of 22 cents per mile for qualifying medical-related travel expenses.
2. Forgetting Social Security’s impact on taxes
It is crucial to keep in mind that when it comes to your Social Security benefits, you will be subject to federal income taxes, the extent of which depends on various factors including your filing status and combined income. While Social Security provides a vital source of income for retirees, it is important to understand that a portion of these benefits may be subject to taxation.
For instance, if you file as single and your combined income falls within the range of $25,000 to $34,000, you will be required to pay income tax on up to 50% of your Social Security benefits.
However, if your combined income exceeds $34,000, the portion of your benefits subject to income tax increases to 85%. These thresholds and tax percentages differ for those who file as married couples filing jointly or as head of household.
3. Forgetting about taxes on side gigs
A significant number of older adults engage in part-time employment or explore side hustles during their retirement years. While this pursuit of additional income can be financially beneficial and provide a sense of purpose, it is essential to understand the potential implications it may have on taxes in order to avoid unexpected tax burdens.
Engaging in part-time work during retirement can have a twofold impact on taxes. Firstly, it directly affects the amount of income tax owed. Any earnings from part-time employment are subject to income tax, just like any other form of income.
Secondly, part-time work can also impact Social Security benefits. If individuals start receiving Social Security benefits before reaching full retirement age and continue to work, there may be an earnings limit that affects the amount of their Social Security benefits.
If their earnings exceed the specified threshold, a portion of their benefits may be temporarily withheld. However, it’s important to note that these withheld benefits are not lost but are recalculated and paid back once full retirement age is reached.
4. Lack of estate planning
The impact of estate taxes on the transfer of wealth to beneficiaries should not be underestimated. These taxes can have significant implications for retirees, especially those who possess substantial assets.
At the federal level, the IRS has established a threshold for estate tax filing, which currently stands at $12.92 million for the year 2023. Estate tax rates imposed by the federal government range from 18% to 40%, depending on the total value of the estate.
Given the potential magnitude of estate taxes, proper estate planning becomes paramount for retirees who possess substantial assets and wish to ensure a smooth transfer of wealth to their beneficiaries.
5. Not claiming tax benefits on donations to charity
Donating to charitable causes not only offers a sense of philanthropic fulfillment but also presents the opportunity for potential tax advantages. By making charitable contributions, individuals can not only support causes close to their hearts but also potentially lower their taxable income.
One tax-savvy approach to charitable giving involves deducting donations from your taxable income. By doing so, you can effectively reduce the amount of income subject to taxation, thus potentially lowering your overall tax liability.
This deduction can be especially beneficial for individuals who itemize their deductions rather than opting for the standard deduction.
6. Retirement account withdrawals taxation
When it comes to retirement accounts, such as traditional IRAs and Roth IRAs, it is essential to understand the distinct tax implications associated with each. Failure to consider the tax consequences before making withdrawals from these accounts can result in unforeseen tax obligations and potential financial setbacks.
One key difference lies in the tax treatment of withdrawals. Roth IRA withdrawals are generally tax-free, provided certain conditions are met. This means that the funds you withdraw from a Roth IRA, including both contributions and earnings, are not subject to income tax.
This tax advantage can be particularly advantageous during retirement when individuals rely on their savings to cover living expenses.
On the other hand, withdrawals from traditional IRAs are subject to income tax. If you withdraw funds from a traditional IRA before reaching the age of 59,5, you may be subject to an additional 10% tax penalty, in addition to the regular income tax on the amount withdrawn.
This penalty aims to discourage early withdrawals and incentivize individuals to preserve their retirement savings until they reach retirement age.
7. Not using tax deductions & credits
It is not uncommon for individuals, including retirees, to overlook valuable tax deductions and credits that they may be eligible for. These overlooked opportunities can potentially lead to missed savings and a higher tax bill. Retirees should be aware of specific tax benefits and credits available to them to optimize their tax situation.
One such benefit is the higher standard deduction available to individuals who are 65 years or older or blind. The standard deduction is a predetermined amount that reduces your taxable income.
Retirees who meet the age or blindness criteria can take advantage of a higher standard deduction, resulting in a lower taxable income and potentially reduced tax liability.
Additionally, for those who choose to itemize their deductions, certain medical and dental expenses, as well as taxes and interest expenses, may be eligible for deduction. Retirees should keep track of their medical and dental costs, as well as any taxes paid and interest accrued, to potentially reduce their taxable income.
