Johnson County Estate Planning

Do I Have to Pay Taxes during Retirement?

“Some retirees may be surprised to learn that a portion of their Social Security benefits could be subject to federal income taxes.”

Paying taxes when you aren’t working but are instead receiving income from a lifetime of working and Social Security is a harsh reality of retirement for many people. Figuring out how much of your income will be consumed by taxes is a tricky task, according to the article “What You Need to Know About Taxes and Your Retirement” from Next Avenue. Ignore it, and your finances will suffer.

Most households will pay about six percent of their retirement income in federal income tax, but that number varies greatly, depending upon the size of their retirement income. The lowest income groups may pay next to nothing, but as income rises, so do the taxes. Married couples with an average combined Social Security benefit of about $33,000, 401(k)/IRA balances of $180,790, and personal financial wealth of $87,000 could find themselves paying 10.5% to 20.9%.

Income taxes and health costs are most people’s biggest expenses in retirement. Income taxes are due on pensions and withdrawals from tax-deferred accounts, including traditional IRAs, 401(k)s, 403(b)s, and similar retirement accounts. The same goes for tax-deferred annuities. Required minimum distributions must be taken starting at age 72.

Roth IRA and 401(k) distributions are tax free, since taxes are paid when the funds go into the accounts, not when they are withdrawn.

If you have investments in addition to your tax-deferred funds, like stocks or bond funds, you also pay taxes on the dividends and interest paid to you. If you sell them, you’ll likely need to pay any capital gains taxes.

Learning that a portion of your Social Security benefits are subject to federal income tax is a shocker to many retirees, but about 40% of recipients do pay taxes on their benefits. The higher your income, the more taxes you’ll need to pay.

There may also be state taxes on your Social Security benefits, depending on where you live.

However, here’s the biggest shocker–if you work part time, you may forfeit benefits, temporarily, if you claim before your Full Retirement Age, while you are working. Claiming before FRA means that your benefits are subject to earnings limits—the most you can make from work before triggering a benefit reduction.

Social Security withholds $1 in benefits for every $2 earned above the annual earnings limitation cap. If you reach your FRA after 2020, that’s $18,240. If you reach your FRA in 2020, the annual exemption amount is $48,600.

Pension, investment income and any government benefits, like unemployment compensation, don’t count towards earned income.

Benefits that are withheld will be returned to you once you hit FRA when Social Security bumps up your monthly benefit to make up for the withholding, but this takes place over time.

Reference: Next Avenue (Sep. 17, 2020) “What You Need to Know About Taxes and Your Retirement”

Are You Making the Most of the SECURE and CARES Acts?

“There have been several law changes that affect IRAs passed since December 2019.”

The SECURE Act made a number of changes to IRAs, effective January 1, 2020. It was followed by the CARES Act, effective March 27, 2020, which brought even more changes. A recent article from the Milwaukee Business Journal, titled “IRA planning tips for changes associated with the SECURE and CARES acts,” explains what account owners need to know.

Setting Every Community Up for Retirement (SECURE) Act

The age when you have to take your RMD increased from 70½ to 72, if you turned 70½ on or before December 31, 2019. Younger than 70½ before 2020? You still must take your RMDs. But, if you can, consider deferring any distributions from your RMD, until you must. This gives your IRA a chance to rebound, rather than locking in any losses from the current market.

Beneficiary rules changed. The “stretch” feature of the IRA was eliminated. Any non-spousal beneficiary of an IRA owner who dies after Dec. 31, 2019, must take the entire amount of the IRA within 10 years after the date of death. The exceptions are those who fall into the “Eligible Designated Beneficiary” category. That includes the surviving spouse, a child under age 18, a disabled or chronically ill beneficiary, or a beneficiary who is not more than ten years younger than the IRA owner. The Eligible Designated Beneficiary can take distributions over their life expectancy, starting in the year after the death of the IRA holder. If your estate plan intended any IRA to be paid to a trust, the trust may include a “conduit IRA” provision. This may not work under the new rules. Talk with your estate planning attorney.

IRA contributions can be made at any age, as long as there is earned income. If you have earned income and are 70 or 71, consider continuing to contribute to a Roth IRA. These assets grow tax free and qualified withdrawals are also tax free. If you plan on making Qualified Charitable Distributions (QCD), you’ll be able to use that contribution (up to $100,000 per year) from the IRA to offset any RMDs for the year and not be treated as a taxable distribution.

Coronavirus Aid, Relief and Economic Security (CARES) Act

The deadline for contributions for traditional or Roth IRAs this year is July 15, 2020. The 2019 limit is $6,000 if you are younger than 50 and $7,000 if you are 50 and older.

RMDs have been waived for 2020. This applies to life expectancy payments. It may be possible to “undo” an RMD, if it meets these qualifications:

• The RMD must have been taken between February 1—May 15 and must be recontributed or rolled over prior to July 15.
• RMDs taken in January or after May 15 are not eligible.
• Only one rollover per person is permitted within the last 12 months.
• Life expectancy payments may not be rolled over.

Individuals impacted by coronavirus may be permitted to take out $100,000 from an IRA with no penalties. They are eligible if they have:

• Been diagnosed with SARS-Cov-2 or COVID-19
• A spouse or dependent has been diagnosed
• Have experienced adverse consequences as a result of being quarantined, furloughed or laid off or having work hours reduced due to the virus, are unable to work because of a lack of child care, closed or reduced hours of a business owned or operated by the individual or due to other factors, as determined by the Secretary of the Treasury.
• Note that these distributions are still taxable, but the income taxes can be spread ratably over a three-year period and are not subject to the 10% early distribution penalty.

Keep careful records, as it is not yet known how any of these distributions/redistributions will be accounted for through tax reporting.

Reference: Milwaukee Business Journal (June 1, 2020) “IRA planning tips for changes associated with the SECURE and CARES acts”

Should You Name a Trust as an IRA Beneficiary?

“For obvious reasons, including control, privacy, asset protection, etc., many clients are interested in putting assets into a trust. For many retirees, their IRA is among their biggest assets. It’s only natural to want to put the IRA into a trust.”

An IRA may not be placed into a trust while the account owner is alive. An IRA also may not be owned by more than one person. The IRA owner can name a trust as a beneficiary of an IRA. Just because you can do this, does not mean it is a good idea, says the article “Naming Your Trust as an IRA Beneficiary” from The Press of Atlantic City. The IRA owner could also take all of the funds and deposit them into a trust, but that would be another bad idea. Why? It is because all of the funds withdrawn would be subject to income tax.

Therefore, why would anyone want to name a trust as the beneficiary for an IRA?

• If you want an heir, like a second spouse, to inherit the income but not the balance of the principal after you have died. This is done so the second spouse cannot name their children as the beneficiary, instead of the original account owner’s children.
• If you are concerned with the ability of heirs to manage your IRA funds wisely, a trust can be the beneficiary and you can set the terms with which the heirs can have access to the funds.
• Minor children cannot be direct beneficiaries of an IRA, and a disabled child may become ineligible for government benefits, if he or she receives an inheritance directly.
• If you want your IRA funds to be inherited by grandchildren instead of children, a trust is the way to go.
• If creditor protection is a concern under the laws of your state, a trust would keep the IRA funds from being tapped by claims of creditors.

Here is why you would NOT want to name a trust as the beneficiary of your IRA:

• There are no tax benefits to having the trust inherit your IRA.
• Trusts have expenses. Trustee fees and tax rates on funds left inside the trust, but not in the IRA, may be substantially higher than personal income tax rates, depending on the beneficiary.
• The trust will have to keep going long after your own death. That means tax returns must be filed, fees paid, and the trustee must maintain the trust.
• Some companies that hold IRAs do not allow trusts to be beneficiaries of IRAs. Before you get into figuring out if this is the right route for you, find out first if your custodian will permit it.

There are many other facts to consider before deciding to name a trust as the beneficiary of an IRA. Speak with your estate planning attorney to see if it is a suitable solution for you and your family.

Reference: The Press of Atlantic City (February 13, 2020) “Naming Your Trust as an IRA Beneficiary”

Will Your Estate Plan Work Now?

“Under the new law, not only must all of the tax on IRAs and plans benefits be paid much earlier than it was before, but the rate will likely be much higher too, since that income will be bundled into the recipients’ peak earning years.”

The demise of the stretch IRA is causing many IRA owners and their advisors to take a look at how their estate plans will work under the new law. An article from Financial Advisor titled “Navigating The New Estate Planning Realities” offers several different planning alternatives.

Take larger IRA distributions during your lifetime. If possible, take the IRA distributions and reinvest them in a Roth IRA or other assets that will receive a stepped-up income tax basis on the death of the account owner. The idea is to take out significant additional penalty-free amounts from IRAs during your lifetime, so you will hopefully be taxed at a lower rate than you would be otherwise, with the net after-tax funds then reinvested in either a Roth IRA or other assets that will receive a stepped-up income tax basis when you die.

Paying all or part of the IRA portion of the estate to lower-income tax bracket beneficiaries. The theory here is that if we have to learn to live with the new tax law, at least we can attempt to minimize the tax pain by doing estate planning with a focus on tax planning. If a person has four children, two in high-income tax brackets and two who are in lower tax brackets, leave the IRA portion of the assets to the children in the lower tax brackets and assets with a stepped-up basis to the higher earners.

Withdrawing additional funds early and using the after-tax amount to purchase income-tax-free life or long-term care insurance. Rather than withdrawing all of the IRA funds early, freeze the current value of the IRA, by withdrawing only the account growth or the RMD portion, whichever is greater. Note that this won’t work if the withdrawals push the person’s income into the next higher tax bracket. All or a portion of the after-tax withdrawals then go into an income-tax-free life insurance policy, including second-to-die life insurance that pays only upon the death of both spouses.

Paying IRA benefits to an income tax-exempt charitable remainder trust. This involves designating an income-tax exempt charitable remainder trust as the beneficiary of the IRA proceeds. Let’s say a $100,000 IRA is made payable to a charitable remainder unitrust that pays three adult children or their survivors 7.5% of the value of the trust corpus (determined annually) each year, until the last child dies. Assume this occurs over the course of 30 years, and that the trust grows at the same 7.5% rate for the next twenty years. The children would net nearly $400,000. Note that the principal of the trust may not be accessed, until it’s paid out to the children, according to the designated schedule.

Every situation is different, so it is important to sit down with your estate planning attorney and review your entire estate, tax liabilities under the new law and how different scenarios will work to both minimize taxes during your lifetime and for your heirs. It’s possible that your situation benefits from a combination of all four strategies.

Reference: Financial Advisor (Feb. 11, 2020) “Navigating The New Estate Planning Realities,”

Retirement Fund Withdrawals Can Affect Social Security Benefits

“Social Security provides a guaranteed source of income in retirement, but what many don't realize is that you're not guaranteed to keep it all.”

Coordinating income in retirement takes a bit more thought than just collecting a paycheck. Take too much from Peter, you’ll end up paying Paul. Some retirees end up owing taxes on their Social Security benefits. If you want to avoid this scenario, master the details as explained in the article “Will My Retirement Fund Withdrawals Affect My Social Security Benefits?” from The Motley Fool.

It all depends upon your income. This is defined as your adjusted gross income, or AGI, plus nontaxable interest plus half of your annual Social Security benefits. The AGI is a person’s income for the year, minus certain tax deductions, like self-employment taxes and contributions to tax-deferred retirement accounts. Withdrawals taken from traditional IRAs or most 401(k)s, which are tax-deferred retirement accounts, do count towards the AGI. However, Roth retirement account withdrawals do not. The only nontaxable interest in your combined income calculation would be tax-exempt bond funds.

For example, a single person with an AGI of $20,000 with $1,000 in non-taxable interest and a $12,000 annual Social Security benefit would have a combined income of $27,000 ($20,000 plus $1,000 plus $6,000 totals $27,000).

Single taxpayers with a combined income of more than $25,000 and married couples filing jointly with a combined income of more than $32,000 could pay taxes on as much as 50% of their Social Security benefits. Single adults with a combined income greater than $24,000 and married couples filing jointly with a combined income greater than $44,000 could owe taxes on as much as 85% of their benefits.

But wait—here’s a detail you need to know. Because you could owe taxes on 50% or 85% of your benefits does not mean you’ll actually pay this much. There’s a Social Security benefit tax formula that will help you understand how this works. Your estate planning attorney or your accountant can help you figure out how this might impact your retirement finances.

Can you avoid these taxes? With the right plan, maybe. Most retiree’s sole source of income is Social Security and withdrawals from retirement accounts. Being smart with those withdrawals, can reduce the likelihood of owing taxes on Social Security benefits.

If you know that you are approaching one of the Social Security threshholds, try to avoid withdrawing more money from tax-deferred retirement accounts. If you have Roth accounts, try to live from them, because they don’t impact your tax status. Another alternative is to pinch pennies for a while, or simply take the plunge and pay the taxes.

Delaying Social Security benefits as long as you can, up to age 70, is another way to reduce the likelihood of owning taxes on benefits. Yes, you can start taking Social Security at age 62, but you must wait to claim your full benefits until you reach your full retirement age. If you start taking benefits early, you’ll get less than your full benefit, and that smaller amount will be permanent.

You can’t pay taxes on benefits that you’re not receiving. Delaying benefits will increase their size, which will reduce the amount to be withdrawn from tax-deferred accounts. This will lower your AGI.

It’s possible that you may not be able to avoid paying taxes on Social Security benefits. However, knowing your unique situation in advance and planning accordingly, will be better than living with a reduced budget because you didn’t know and didn’t plan.

Reference: The Motley Fool (Jan. 17, 2020) “Will My Retirement Fund Withdrawals Affect My Social Security Benefits?”

Common Retiree Mistakes You Can Avoid

“Retirees preparing to file their taxes for this year should be aware of a number of common pitfalls, often-overlooked deductions and changes that stem from the tax overhaul two years ago.”

Did you know that there is a new federal income-tax form for seniors designed to make filing taxes easier this year, especially for those who don’t file electronically? It offers a larger font for easier reading and includes a chart designed to help taxpayers calculate their standard deduction. However, that’s not all that has changed. The Tax Cuts and Jobs Act of 2017 (TCJA) has made for many changes that are often overlooked, reports Barron’s in the article “Retiree Taxes: Pitfalls, Overlooked Deductions, Social Security Withholding”

People who turn 70½ in 2019 may take their required minimum distribution as late as April 1, 2020.  However, they must take their 2020 distribution by December 31, 2020, and a double distribution in one year may bump them into another tax bracket. Start planning now for your 2020 distributions. Here are more tips for the coming tax year.

Standard Deduction. Many itemized deductions from 2018-2025 have been eliminated or restricted, and the standard-deduction thresholds were raised. For many taxpayers, itemizing deductions simply doesn’t pay, especially for anyone who has paid off their mortgage and can’t include interest in their deductions. However, there is a way for seniors to benefit from charitable distributions. Those 70½ or older can donate up to $100,000 from their IRAs or Roth IRA directly to a charitable organization and that donation is not counted as taxable income. Note that the contribution must come directly from the custodian on the taxpayer’s behalf.

Medical Expenses. The threshold for medical expenses in tax year 2019 will revert to the prior level, after it was lowered in 2017 and 2018 by the new tax law. For 2019, taxpayers can deduct unreimbursed medical-care expenses that exceed 10% of their adjusted gross income—their taxable income minus any adjustments to include such as deductions, contributions to Health Savings Accounts, or contributions to traditional IRAs, among others.

Social Security Benefits Taxes. Whether Social Security benefits are taxable or not depends on the filer’s income level. If the person’s combined income—their adjusted gross income plus any tax-exempt interest plus half of their Social Security benefit—is more than $25,000 for those filing single, head of household or a qualifying widow or widower with a dependent child, or more than $32,000 for joint filer, their benefits will be taxed.

It may be too late for tax year 2019, but taxpayers can avoid a tax surprise in 2020, by having federal income taxes withheld from Social Security benefits using IRS Form W-4V or from their pension using form W-4P.

Reference: Barron’s (November 2, 2019) “Retiree Taxes: Pitfalls, Overlooked Deductions, Social Security Withholding”

Why You Should Not Use 401(k) Funds to Pay A Mortgage

“When it comes to your money, be careful who you listen to. Taking advice from an uninformed person can cost you dearly.”

We call it “the brother-in-law” effect. Most families have a brother-in-law who likes to think he knows everything, and he’s more than happy to share his wealth of knowledge. Trouble is, most of what he knows is wrong. A 60-year-old woman was told that she could use her 401(k) or IRA funds to pay off her mortgage and never have to pay any taxes, or not until she sold her home. This, says The Washington Post’s article “Sorry, you can’t escape income taxes by using 401(k) funds to pay off your mortgage,” is a perfect example of someone giving really, seriously, bad information.

Let’s start by clarifying how 401(k) and IRA plans work. With a traditional 401(k), contributions are made on a pretax basis. Income taxes are then due on both contributions and earnings, when distributions are taken. There is a 10% tax penalty, if the money is taken out before the account owner reaches age 59½.

Depending on the person’s income, contributions to a traditional IRA may be deductible from taxable income. Income taxes aren’t due, until the money is withdrawn. With a Roth 401(k), contributions are made after taxes have been paid, so there are no income taxes due when money is withdrawn.

Is there a loophole for mortgages? The short answer is no.

There are relief provisions for the 10% additional tax, but since this person is past the 59.5 threshold, that is not an issue in the situation described above. Distributions from a Roth IRA or a Roth 401(k) are different, but even then, there wouldn’t be anything special about the distributions being used to pay a mortgage.

While you might not incur a penalty because of the age issue, any distributions would be subject to income tax. If the money has already been taken out of the IRA, the woman may have a 60-day window to put the money back in the account without being taxed—unless she has already used this rollover treatment within the last 365 days.

There is a special provision for first-time home buyers under 59.5 to use IRA money to avoid the 10% early withdrawal penalty, but that doesn’t apply here.

Using retirement funds to pay off or pay down a mortgage requires a careful analysis of the costs, in terms of penalties, taxes, and future costs.

One potentially compelling reason would be a senior who has more than enough money saved for retirement and simply wishes to retire debt-free. Another would be a homeowner who is in a low-income tax bracket but will also be taking the standard deduction each year. If that person is paying interest on a 4.5 percent mortgage without receiving any tax benefits, then it could make sense to withdraw money from an IRA and pay off the mortgage. However, the withdrawal will be treated as income, so that needs to be part of the analysis.

Generally speaking, the best use for retirement money is retirement. Keeping accounts intact for use later in life while enjoying tax-deferred growth is the real reason for these accounts.

Reference: The Washington Post (October 30, 2019) “Sorry, you can’t escape income taxes by using 401(k) funds to pay off your mortgage”

Roth IRA Conversion Is Popular but Not for Everyone

A cost comes along with a Roth conversion and you can lose some tax deferral.

Americans have moved more than $75 million, since Congress approved the partial or full IRA conversion to a Roth IRA.  However, while it is popular, it doesn’t always work out for the best, according to The Wall Street Journal in “When to Ignore the Crowd and Shun a Roth IRA.”

Retirement funds that go into a Roth get tax-free growth and tax-free withdrawals, minus any required payouts based on age, which is a sticking point for IRA owners.

A traditional IRA grows tax free, but withdrawals are taxed as ordinary income. Those pesky Required Minimum Distributions (RMDs) are also a permanent fixture, even if you don’t need the money.

However, Roth conversions come at a cost. You’ll have to pay a tax to transfer your money from the traditional IRA to the Roth and you may lose valuable tax deferral, without gaining more valuable tax-free benefits.

This is a deadline to bear in mind: after tax year 2018, you won’t be allowed to undo a Roth conversion.

What are some further reasons to take a pass on the IRA Roth conversion train?

Your tax rate is probably going down. If your tax rate is going to be lower when you take withdrawals, the transfer will cost more. If you are going to convert, do so in a low tax-rate year when income takes a dive. For instance, if you are in your 20s and have an IRA and return to school, or if you’ve retired but aren’t yet taking IRA RMDs.

The same goes for someone who is about to move to a state where taxes are lower.

Where is the money coming from to pay the tax bill for the conversion? If you don’t have the money to pay the tax bill and plan on using money from the IRA to pay it, you’re using assets that could otherwise grow tax free.

Converting to an IRA raises your income level for that year. Therefore, benefits that exist at a lower income tax level might lose value as your income takes a leap. Tax breaks for college or other deductions could be lost.

If you make frequent donations to charity, you can use your traditional IRA’s RMD to donate to charity. The donation can count toward your required payout, up to $100,000 per year from your IRA. You can’t do that with a Roth.

An estate planning attorney can advise you on creating an estate plan that fits your unique circumstances and may include a Roth IRA conversion.

Reference: The Wall Street Journal (Aug. 17, 2018) “When to Ignore the Crowd and Shun a Roth IRA”