5 Commonly Missed Tax Planning Strategies in Retirement

Retirerees often make costly mistakes in their tax planning strategies. Here' s a look at five of the most common missed benefits and ways to remedy these mistakes.

1. Less is not always more

One common error made in retirement is not having enough income. I know this sounds a bit counterintuitive, so let me explain. Many retirees assume that deferring as much income as long as possible is the best strategy, thinking that paying tax later is better. Unfortunately, if your adjusted gross income is less than the total of your itemized deductions plus your personal exemption, you are actually losing the benefit of your itemized deductions. Generally, you want to plan to withdraw enough out of your retirement accounts to have a positive taxable income.

2. Beware of the Hidden Social Security Tax

A portion of a taxpayer's social security may be taxable. The includible amount is the lesser of one-half of the annual benefits received or one-half of the excess of the taxpayer's provisional income over a specified base amount, at lower provisional income levels. However, at higher provisional income levels, up to 85 percent of the social security benefits may be included (see 85 percent inclusion, following).

Provisional income is the taxpayer's modified adjusted gross income plus one-half of the social security. Modified adjusted gross income is the taxpayer's adjusted gross income plus (1) any tax-exempt interest, including interest earned on savings bonds used to finance higher education; and (2) amounts excluded under an employer's adoption assistance program, deducted for interest on education loans or as a qualified tuition expense, or earned in a foreign country, a U.S. possession, or Puerto Rico and excludable from gross income. The base amount is: (1) $32,000 for joint filers; (2) $0 if married filing separately and the taxpayer lived with his or her spouse at any time during the year; and (3) $25,000 married individuals filing separately who live apart from their spouse for the entire year and individuals filing as single or head-of-household.

Example 1

John and Jane Mapes have an adjusted gross income of $24,000 for 2011. John, who is retired, receives social security benefits of $7,200 per year. The couple also receives $6,000 a year from a mutual fund that invests solely in tax-exempt municipal bonds. On their joint return for 2011, the Mapes' would make the following computation to determine how much, if any, of John's social security benefits must be included in their gross income:

Up to 85 percent of an individual's social security benefits may be includible in gross income. The rules affect married taxpayers filing jointly with provisional income in excess of $44,000, married taxpayers filing separately and not living apart the entire year with provisional income in excess of $0, and all other taxpayers with provisional income in excess of $34,000.

Those who exceed the higher threshold adjusted base amounts must include in income the lesser of: (1) 85 percent of social security benefits or (2) 85 percent of the excess of provisional income over the threshold amount, plus the smaller of: (a) the amount that would otherwise be includible if the second threshold did not apply, i.e., the amount calculated under the 50-percent rules discussed previously, or (b) $4,500 ($6,000 for joint filers).

Example 2

Assume the same facts as in Example 1 above, except that the Mapes' provisional income is increased from $33,600 to $53,600. The includible amount is determined as follows:

In this scenario, taxable income increased by 20,000, but their effective tax rate increased by 40 percent (from 11.5 percent to 16 percent), and resulted in $916 of additional tax on the Social Security.

Plan to take the Credit for the Elderly. There's a special tax credit for taxpayers age 65 or older. But qualifying for the credit takes careful planning. Your adjusted gross income must fall beneath certain limits.

3. RMD stands for Required Minimum Distribution-consider Required Maximum Distribution

Once you reach age 70-1/2, you are required to withdraw from your qualified retirement account a minimum each year. From a family wealth planning perspective, if you have a taxable estate, consider taking more if it keeps you in the same tax bracket. This is especially important if your heirs ordinary income rate is higher than yours. This allows you to pass after tax dollars to your heirs, and reduces the estate tax due to the government.

4. Income is Sometimes Better in Bunches

As I discussed in No.2 above, social security planning can be critical. Taking income over time (for example an installment sale of land) may create a situation that makes your social security taxable each year that you report the installment sale gains. As of the date of this article, capital gains rates are slated to increase, and there will be the Obamacare tax surcharge as well. Consider reporting all of the gain in 2012 rather than using the installment sale. While you are front-loading the tax, it may significantly reduce your overall taxes.

5. Inheritance is Not all it is Cracked-Up to Be

One little known tax planning technique is the ability to "disclaim" an inheritance. With the population living longer, it is often common to receive an inheritance when you are in retirement. Your children, however, might be in the midst of providing for your grandchildren, and making their own way. If you receive an inheritance, you might consider saying no thanks, or disclaiming it. The will or trust of the descendant will generally provide that if you decide you don't want it, it will go to your children. This is especially important if the gift is going to be subject to tax (such as an IRA), and your children's tax rate is lower than yours. It also keeps assets being taxed on your death, if you will have a taxable estate.

Mike Bosma is managing shareholder of The Bosma Group. Contact him by phone at 786-4900 or by e-mail at mbosma@thebosmagroup.com.