A lax understanding of taxable retirement income is just one of several retirement mistakes to avoid. With the help of an expert financial advisor, you can dodge most of these retirement planning pitfalls.
Just because you’ve stopped working doesn’t mean you stop paying taxes. Mismanaging your retirement planning can lead to unnecessary taxes and fees associated with IRA withdrawals and your Social Security benefits. (Yes, your Social Security is susceptible to taxes under certain circumstances.) A lax understanding of taxable retirement income is just one of several retirement mistakes to avoid. With the help of an expert financial advisor, you can dodge most of these retirement planning pitfalls.
Mistake #1 – Not Understanding RMDs
The IRS has a clock counting down that starts the day you put any pre-tax money into a retire account. That clock ticks in the form of RMDs, or Required Minimum Distributions. RMDs are annual minimum withdrawals your retirement accounts after your 72nd birthday. Those accounts include IRAs, 401ks, and 457 plans. RMDs also apply to other tax-deferred retirement accounts like TSPs, 403(b)s, TSAs, SEP IRAs, and SIMPLE IRAs. In short, any tax-deferred money you’ve saved during your career or earned through retirement account investment gains is subject to taxation upon withdrawal.
Not withdrawing your RMDs on time is one of the most crucial retirement mistakes to avoid.
If you were born on or after July 1st, 1949: As of your 72nd birthday, the law requires you to take your first RMD by April 1st of the following year, your second RMD by December 31st of that same calendar year, and then again every year thereafter before December 31st.
If you were born before July 1st, 1949: You were required to begin taking RMDs six months after your 70th birthday and should be taking a withdrawal every year before December 31st.
So how much do you have to withdraw from your retirement accounts to meet your RMD obligation? The first step in calculating your RMD is knowing your account balance as of December 31st of the prior year. Then, using the IRS worksheet for RMD calculation, determine your denominator. Divide the account balance number by the denominator calculated by the worksheet, and you have your RMD amount. (Whereas your numerator will always be the previous year’s account balance, your denominator will become smaller each year—thus making the percentage withdrawn larger each year).
Let’s say Andrew has $250,000 saved in his 401(k). He turned 72 in 2021 and is looking to make his first RMD early to avoid doubling down next year. According to the IRS worksheet, Andrew’s distribution period is 25.6. Applying the formula, 250,000 divided by 25.6 = $9,765 in RMD. That means Andrew must withdraw $9,765 from his 401(k) before April 1st of 2022 and include it on his tax return.
The penalty for not taking your annual RMD is steep, and one of the most serious retirement mistakes to avoid. If you fail to withdraw, you’ll pay a 50% tax on the expected amount. So, if Andrew doesn’t withdraw his first RMD by April 1st, he’ll pay a $4,882 fee, which is far more than he’d pay in income tax for the total RMD alone.
Mistake #2 – Failing to Withhold Taxes on Social Security and Pension Benefits
You’ll continue paying taxes well into retirement. Misunderstanding how benefits income shows up on your annual tax return and failing to make the proper deductions are key retirement mistakes to avoid. When working with a financial advisor, you can accurately estimate what you’ll pay in taxes each year based on your benefits, including your pension, Social Security, RMDs, and annuities.
Social Security (SS) and pension payments are the most common forms of income after retirement. Social Security payments are generally tax-exempt if not combined with other income streams. However, as soon as other sources of income become involved (like investment gains, royalties, or self-employment), you then have to include up to 85% of your SS benefits on your tax return as taxable income. This IRS worksheet will help you determine if your SS benefits are taxable.
Most pensions are funded with pre-tax money, so you will have to pay taxes on anything you withdraw. Any pension payments you receive are considered taxable forms of income and must be reported. Of course, you can always have taxes withheld from your pension check to avoid the headache come tax season.
Mistake #3 – Not Strategically Choosing How and When to Withdraw Income
Some think taking SS as early as 62 is the right move to make financially. While it may seem like a smart move—why avoid taking money you’re entitled to?—drawing on your retirement benefits (and the thousands more accrued in taxes each year as a result) can snowball into one of your biggest retirement mistakes. The most common reason for taking early SS is the uncertainty of tomorrow. You may die before taking advantage of your retirement benefits, so why give that money back to the government?
SS withdrawals tie into what the Social Security office calls your full retirement age. Taking SS before your full retirement age can reduce it by upwards of 25%. For example, a $1,000 monthly payment will be reduced to $750 if withdrawn early. While you’ll be getting the money earlier, you’ll be getting less. Use this full retirement age chart to determine how much less you’d be making by taking SS ahead of retirement age. Delaying your SS benefits until after your full retirement age will also earn you delayed retirement credits, thus a larger monthly payment.
Remember, up to 85% of your SS income is susceptible to taxation based on other forms of income. You may still be working at 62 and making plenty of additional income to support yourself without SS. Taking SS too soon could see it lumped into your other income, thus handing it right back to the government.
Don’t Make These Mistakes—Hire a Wealth Manager
Regardless of your income level, it is important to begin planning your retirement finances as early as possible. Work with a financial advisor to build a retirement strategy that minimizes tax payments wherever possible. They can help steer you away from the retirement mistakes you need to avoid and guide you through the complex world of Social Security taxation and RMDs. Your financial team at Polaris Wealth Advisory Group is here to ensure you make savvy financial decisions as you enjoy your well-deserved retirement. Reach out today to get planning!
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