If you’re not careful, hidden tax traps can turn your golden years into a headache. It's really important to understand how taxes are going to impact you in the future.

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As a Certified Financial Planner with over a decade of experience helping retirees here in Frisco, TX, I’ve seen firsthand how easily these tax traps can sneak up on even the most diligent savers.

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Today, I’ll walk you through the three most common tax traps retirees forget and share strategies to beat them, ensuring you keep more of your hard-earned money.

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Tax Trap 1: Required Minimum Distributions (RMDs)

When you hit your 70s, the government starts taking its cut from your retirement savings through Required Minimum Distributions (RMDs). These are forced withdrawals from your qualified accounts (I say "forced" because they are not by choice), and if you fail to take them, you’ll face a hefty 25% penalty.

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These forced distributions apply to any qualified savings you have: your 401k, Traditional IRA, your 403b, 457, your TSP, SIMPLE IRA, SEP IRA, etc. If you were born between 1951-1959, your required beginning date (RBD) is age 73. If you were born after 1960, it's age 75.

When you reach your required beginning date, your silent partner (the government) raises their hand and says, "it’s my turn to cash out on my portion!".

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Once you reach your RBD, you must start withdrawing a percentage of your investments. That money will move out from your IRA or 401k, and taxes will be due.  Some people spend what’s left over, other people save and re-invest the net amount. It's completely up to you.

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The percentage you take out differs depending on what type of beneficiary you are. If it’s your own qualified money or you inherited it from your spouse, then you use the uniform life table.  But if you are not a spouse, then you use a different table called the single life table.  The more favorable of these would be the uniform life table.  

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People often ask what percentage is required each year for RMDs. The percentage is based on a specific factor, which for the uniform life table starts at 3.65% for a 73-year-old and increases each year.

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Let’s take a look:

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Uniform Lifetime Table Percentages

Age 73: Approx. 3.65%

Age 75: Approx. 3.91%

Age 80: Approx. 4.95%

Age 85: Approx. 6.25%

Age 90: Approx. 8.20%

Age 95: Approx. 11.63%

Age 100: Approx. 15.87%

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Of course RMD’s are important to pay attention to because if we don’t pull the money out, we get penalized. And when we do pull it out, we pay taxes. Those dollars mix with your Social Security income and create even more taxes. The trap here really happens when a couple happily retires in their 60s with a manageable annual tax bill, but when they turn 73 or 75, taxes skyrocket up.

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However, there are strategies to defuse this tax bomb.

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Strategies to Beat the RMD Trap:

Advance Your Income Early

‍Why it works: The idea of advancing your income early works well because it smooths out your tax horizon. Essentially, you’re withdrawing money from your IRAs and 401(k)s before you actually need to spend it. This strategy is beneficial because you’re currently in a lower tax bracket than you expect to be in the future.

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For example, we had a client who was still working full-time but decided to transition to part-time work. By withdrawing and spending money from his retirement accounts monthly, he was able to supplement his income, reducing the need to work full-time. This move not only provided him with additional flexibility but also helped manage his tax bill more effectively.

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However, advancing income early doesn’t just mean spending the money. You could also re-save it in a brokerage account, use it to make gifts, or invest in life insurance to expand your legacy. The core idea is to take advantage of your current lower tax bracket to reduce future tax liabilities. By doing so, you’re proactively managing your taxes and potentially freeing up more income for your retirement years.

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Roth Conversions

Convert some of your IRA funds into a Roth IRA, where future withdrawals are tax-free.

Roth conversions involve moving money from your traditional IRA or 401(k) into a Roth IRA. While you'll pay taxes on the amount converted at your current rate, this strategy offers long-term benefits.

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Why it works: By converting to a Roth IRA, you pay taxes on the converted amount now, but future withdrawals from the Roth IRA will be tax-free. This can be particularly advantageous if you expect your tax rate to be higher in the future.

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How to execute: Evaluate your current tax bracket and project your future tax situation. If you’re in a lower tax bracket now compared to what you expect in retirement, it might be wise to convert some of your traditional IRA funds to a Roth IRA. This move also helps in managing Required Minimum Distributions (RMDs) since Roth IRAs are not subject to RMDs during your lifetime.

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For example, a client nearing retirement might convert a portion of their traditional IRA to a Roth IRA while still in a lower tax bracket. This strategy can prevent a larger tax bill when required distributions kick in at age 73 or 75, thereby providing a more predictable tax situation in the future.

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Qualified Charitable Distributions (QCDs)

Qualified Charitable Distributions allow you to make donations directly from your IRA to a qualified charity. If you’re over the age of 70½, you can take advantage of this strategy.

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Why it works: By using QCDs, you can satisfy your RMD requirements while reducing your taxable income. This can be particularly helpful if you're charitably inclined and want to lower your tax bill.

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How to execute: Directly transfer funds from your IRA to a qualified charity. This distribution counts towards your RMD and is excluded from your taxable income for the year.

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For example, if you’re a retiree who regularly donates to charities, consider using QCDs to manage your RMDs and reduce your taxable income. For instance, if you need to take an RMD of $10,000, and you donate $5,000 directly to a charity via a QCD, only $5,000 will be added to your taxable income, thus reducing your overall tax liability.

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Tax Trap 2: Healthcare Costs and Medicare Premiums

Retirees often find themselves blindsided by the tax impact of healthcare costs. In Frisco, for example, the cost of living can be HIGH, so it’s essential to understand how healthcare expenses can impact your taxes.

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When we hit 65, we shift from private health insurance to Medicare, and suddenly, we’re paying for monthly premiums. While Medicare Part B and Part D premiums are relatively predictable, out-of-pocket healthcare costs can be surprisingly high. Medicare Part B, which covers doctor visits, costs about $174.70 a month. Part D, for prescription drugs, runs around $32.74. So, if you’re a couple, you’re looking at just over $400 a month for these basics.

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But here’s where things can get tricky. The monthly Medicare premiums are just the beginning. A study by T. Rowe Price found that out-of-pocket costs for healthcare, which aren’t covered by Medicare, can add another $200 to $400 per month per person. That’s a significant extra chunk of change that’s not always on your radar.

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To make matters even more complicated, Medicare doesn’t cover long-term care or custodial needs. So, if you find yourself needing extra help with daily activities or long-term healthcare, you’ll have to cover those costs yourself. Paying for these additional healthcare expenses can push your income higher for the year.

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Why does this matter? Because when your income goes up, you might end up in a higher tax bracket, and you might also face something called IRMAA (Income-Related Monthly Adjustment Amount), which is an extra charge on your Medicare premiums based on your income. So, paying for out-of-pocket healthcare costs not only boosts your income, leading to higher taxes, but it also makes your Medicare premiums more expensive.

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For higher-income retirees, this domino effect is even more pronounced. You might not think you’re a high-income retiree, but once you start spending significant amounts on medical expenses, you might find yourself in a higher tax bracket than expected. And when you factor in the increased cost of Medicare, your disposable income shrinks.

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Here's how to avoid the healthcare cost trap:

One of the best ways to avoid falling into the tax trap with Medicare costs is to understand how IRMAA (Income-Related Monthly Adjustment Amount) works and regularly evaluate your tax situation.

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IRMAA is based on income tiers, but it’s not determined by your Adjusted Gross Income (AGI). Instead, it’s based on your Modified Adjusted Gross Income (MAGI). MAGI can be higher than AGI because it includes additional elements like tax-exempt interest, foreign income, and the deductible part of self-employment tax.

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For instance, if your AGI is $96,000 and you’re single, but you have $5,000 in tax-exempt interest, that additional income could push you into a higher IRMAA bracket. IRMAA has a cliff effect, meaning if you exceed a threshold by just one dollar, you’ll pay the full extra premium amount.

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Here’s a real-life example: One of our clients in Frisco recently reached out to their advisor, Tori, wanting to withdraw extra money to pay off their car early. Tori noticed that this additional withdrawal would likely push them into a higher Medicare cost bracket. Thanks to this insight, they decided against the extra withdrawal.

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For a clearer picture, check out the 2024 IRMAA chart:

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For 2024, if you’re single and exceed $97,000 in MAGI by even $1, you’ll pay an extra $68 per month for Part B and $12.20 for Part D. That adds up to about $1,000 more per year, on top of the normal $2,000 bill for the base levels of Part B and D. For married couples, if your MAGI exceeds $194,000 by just $1, you’ll pay double that amount—an additional $2,000 per year, plus the base costs.

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To navigate around these extra costs, consider alternative strategies. Instead of withdrawing from your IRA, you might use income from other sources like CDs or savings. Alternatively, you could finance a purchase like a car for a year or two to spread out your withdrawals and keep your income within a manageable range.

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Tax Trap 3: Capital Gains and Investment Income

What am I talking about?!? Well, income comes in various forms, and how it’s taxed can differ significantly. Basic income from working, including self-employment income, is considered ordinary income and is taxed according to our progressive tax system.

But then, there’s investment income, which can be taxed at rates ranging from 0% to 37%.

Let’s break this down into two main categories: Capital Gains & Dividends.

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Capital Gains

Short-Term Gains: If you sell an investment that has increased in value within a year of purchasing it, you’re taxed at your ordinary income rate.

Long-Term Gains: If you hold an investment for more than a year before selling it, it qualifies for a more favorable long-term capital gains (LTCG) rate of 0%, 15%, or 20%, which is generally lower than your ordinary tax rate.

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Dividends

Qualified Dividends: These dividends are paid from investments you own and are taxed at the same favorable rates as LTCG—0%, 15%, or 20%.

Non-Qualified Dividends: These dividends are taxed as ordinary income, so they don’t receive that favorable treatment.

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Why This Matters: Understanding the timing and type of your investments is crucial for tax efficiency:

- Timing: Holding an investment for over a year can qualify you for the lower LTCG rate instead of being taxed at the ordinary income rate.

- Type: The type of investment affects the tax rate on your dividends. For example, U.S. stocks from companies known for dividend growth, like Johnson & Johnson, Procter & Gamble, and Coca-Cola, often pay qualified dividends. On the other hand, high-yield bonds and Real Estate Investment Trusts (REITs) usually produce non-qualified dividends.

It’s important to know how your investments impact your tax liabilities. For instance, a family we recently met had all their dividend stocks and high-yield bonds in a non-qualified brokerage account. After understanding the tax implications, they decided to shift these investments into their qualified accounts to optimize their tax situation.

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Proactive Tax Planning: Effective tax planning can help you minimize your tax bill and keep more of your wealth.

Strategies include:

- Tax Loss Harvesting

- Tax Gain Harvesting

- Qualified Charitable Distributions (QCD)

- Required Minimum Distribution (RMD) Planning

- Tax-Optimized Allocation

- Early Income Advancement

- Order of Withdrawals Planning

- Roth Conversions

- Strategic Use of Life Insurance

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Planning ahead for how you handle your taxes in retirement is worth the effort. It can preserve more of your wealth for you and your heirs.

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Now that you know about these tax traps and how to avoid them, you can better prepare for a retirement that beats these challenges. If you want a team of experts to review your specific situation and help you design a plan for a stress-free retirement, click here to book a no-cost consultation with my team.

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Click here to watch the full Youtube video that provides a full rundown of this topic!

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