If you're nearing retirement or already retired, it’s important to understand how taxes (including recent changes to them) impact your retirement income, as it may be possible for you to pay less in taxes on your hard-earned dollars.
Since each person's tax situation is unique, and the tax rules can change year to year, it can be challenging to get accurate and timely information. This article helps you navigate the retirement tax maze, which can seem daunting at first glance. It delivers comprehensive information regarding retirement taxation and ways to efficiently harvest your income source—whether they are Social Security, 401(k)/IRA, other sources, or a combination of them all. The sections below can better position you to develop a successful retirement tax strategy that can potentially safeguard you from over-taxation—all with the goal of saving you money.
What To Know About Biden’s 2022 Tax Plan
At over 100 pages, the U.S. Department of Treasury’s “General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals” can be a dense read for even the most experienced financial planner.1 So what do you need to know?
President Joe Biden’s 2022 budget proposal raises the top income tax rate up to 39.6%. Additionally, taxpayers with an adjusted gross income of more than $1 million will also have to pay this rate on long-term capital gains and qualified dividends. However, the proposal could also benefit tax-deferred retirement plans like 401(k)s for low- and middle-class taxpayers.
Under the 2022 proposal, investors who move money into a Roth IRA will have to pay taxes up-front—but once you are older than 59.5 years and hold the account for more than five years, you can make tax-free withdrawals. If approved, this means high-income investors may be able to save money by paying a lower rate now.
For investors moving money into tax-deferred retirement accounts like 401(k)s, the proposal will still give them the ability to postpone taxes on the money they invest until withdrawal. This can provide some added flexibility, giving you the ability to limit the amount you take out to keep income beneath the top tax rate.
Keep in mind that Roth IRAs have income limits that exclude high-income investors from contributing. Only individuals making less than $144,000 in 2022 and joint filers under $214,000 are eligible. However, the IRS does allow individuals in this bracket to move money from traditional IRAs or 401(k)s to Roth IRAs through a conversion—we’ll go over this shortly.
An important consideration to note is that pre-retirees may notice fluctuations in their retirement portfolio if the tax increases trigger a stock market sell-off. However, a proactive income strategy can help mitigate these effects in the long term.
Keep in mind that the 2022 proposal is simply that: a proposal. A similar overhaul of tax regulations recently fell through, meaning that there is still the potential for this framework to significantly change before it becomes official. If you’re not sure how to navigate upcoming changes to the tax environment, a financial advisor can help provide advice on which strategies make the most sense for your goals.
How Where You Live Factors Into Retirement Taxes
No matter the president or whether the proposal is approved, one of the most important decisions you’ll make is where you’ll retire.
Whether you're thinking about downsizing or are simply in the mood for a change of scenery, you're far from alone if you officially decide to relocate during retirement. In fact, according to data from the U.S. Census Bureau’s Current Population Survey, the number of relocating retirees in 2020 marked a 30% year-over-year increase from the 2019 figure of 397,0002. However, it’s important to consider far more factors aside from the weather as you pick your home for retirement.
Kiplinger has ranked all 50 states based on how friendly the tax environment is to retirees based on the four following factors3:
- State income tax rate
- Average combined state and local sales tax rate
- Median property tax rate
- Estate tax or inheritance tax
Research shows that some of the best states to retire for tax reasons are currently Alabama, Hawaii, Illinois, Mississippi, and Pennsylvania. Soon to be joining the “most-friendly” list may be Iowa and Michigan, with MoneyTalksNews reporting both states are on track to potentially eliminate retirement income taxes entirely4.
On the other hand, investors likely won’t be surprised to learn New Jersey and the Constitution State—Connecticut—can both quickly prove to be states with daunting tax challenges.
It’s important to remember that no state is off-limits to taxation when it comes to your retirement. A bit of proactive planning and research, as it relates to the state’s cost of living and your own day-to-day expenses, can go a long way. Plus, if you do decide to sell your home in the process of moving, the IRS allows you to exclude up to $250,000 of capital gains from your income after the sale of your house. If you’re married, the exclusion increases to $500,000.6
Methods To Minimize Taxes
With the 2022 tax proposal making headway, many retirees are looking for potential tax deductions and credits that can help to combat taxes in the long term.
Claiming the Higher Standard Deduction
When filing, you have the choice between claiming the standard deduction or itemizing your deductions. For those over the age of 65, the IRS offers a higher standard deduction for deciding to do the former.
Many retirees who meet this age requirement may find that their standard deduction plus the extra standard deduction for age works out to be more than any itemized expenses they can claim. You’ll likely fall into this category if you have paid off your mortgage and no longer have that itemized interest deduction. However, be sure to consider whether itemizing other deductibles, such as your property taxes and medical bills, would outweigh the benefit.
For example, if you decide to itemize, you may have the opportunity to deduct unreimbursed medical expenses—but the IRS only permits amounts that exceed 7.5% of your adjusted gross income5.
Extra IRA Contributions
Contributions to a 401(k) are tax-advantaged, meaning that the IRS places a cap on how much you can contribute each year7. For those who are under 50, that limit is $19,500 in 2021 and $20,500 in 2022. If you’re 50 or older, though, you can put in $26,000 in 2021 and $27,000 in 2022. However, if you aren’t still working and are older than 50, you can take advantage of the catch-up provision and contribute an additional $1,000 annually.
Consider a Roth Conversion
One of the earliest forms of the proposed tax bill had included putting an end to non-deductible backdoor Roth conversions. This means that regardless of income level, investors would no longer be able to convert after-tax contributions made to a 401(k) or a traditional IRA to a Roth IRA. With this strategy still available as of 2022, let’s go over what the process looks like and who it may benefit.
By undergoing a Roth conversion, account holders can move a portion of their traditional IRA balance—which is funded with pretax dollars—into a Roth IRA and pay the tax on that distribution at the moment. By paying the income tax now, your contributions and earnings are able to grow tax-free into the future inside the Roth IRA.
This strategy is especially useful for investors who anticipate being in a higher tax bracket later in life, and can also be used as a way to shield assets from potential law changes under the current or future administration.
Depending on your unique financial positioning and goals for retirement, there may be several other opportunities available to you when it comes to minimizing the impact of taxes on your income.
Stay Ahead of Taxes During Retirement
Remember: although each investor faces a unique tax situation, the best retirement plan is always a proactive one. While you can’t fully predict how federal laws and regulations will change with each administration, striving to create a diversified portfolio that aligns with your personal goals can position you for long-term financial wellness. Remember, when in retirement, tax diversification can help you structure withdrawals to potentially reduce taxes and increase the amount of your after-tax spendable income.
We provide life-focused financial planning, which means that we help you discover how to be more intentional about your life and personal finances. We believe that a rich life is not about how much money you have, but rather the sense of personal fulfillment derived from life's journey. If you are approaching the retirement phase of your life, let us help you make that transition by scheduling an introductory meeting today.
This content is developed from sources believed to be providing accurate information, and provided by Integrity Financial Planning, LLC. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.
- U.S. Department of the Treasury. (2022). General explanations of the - U.S. Department of the Treasury. U.S. Department of the Treasury. Retrieved February 21, 2022, from https://home.treasury.gov/system/files/131/General-Explanations-FY2022.pdf
- Mengle, R., Muhlbaum, D., & Niedt, B. (2022, February 18). Taxes in Retirement: How all 50 states tax retirees. Kiplinger. Retrieved February 21, 2022, from https://www.kiplinger.com/retirement/602202/taxes-in-retirement-how-all-50-states-tax-retirees
- Kissell, C. (2022, February 11). 2 states that soon might eliminate retirement income taxes. MoneyTalkNews. Retrieved February 21, 2022, from https://www.moneytalksnews.com/2-states-that-soon-might-eliminate-retirement-income-taxes/
- IRS. (2022, February 11). Topic No. 502 Medical and Dental Expenses. Internal Revenue Service. Retrieved February 21, 2022, from https://www.irs.gov/taxtopics/tc502#:~:text=You%20may%20deduct%20only%20the,of%20your%20adjusted%20gross%20income.
- Topic no. 701 Sale of your home. Internal Revenue Service. (2022). Retrieved February 16, 2022, from https://www.irs.gov/taxtopics/tc701
- IRS. (2021). Retirement topics - IRA contribution limits. Internal Revenue Service. Retrieved February 21, 2022, from https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits