Tax Tips and Traps for Recent Retirees

Life may be simpler after retirement, but for many, taxes can get a lot more complicated. New sources of income with new tax rules and new tax payment responsibilities can confuse and confound even the most tax-savvy retirees.

Retirement Income

Following retirement, your clients will most likely begin to draw down the retirement savings they have accumulated over the years.

Retirement plan distributions. Pension payments are generally fully taxable unless your client contributed to the plan. Moreover, the same generally holds true for distributions from 401(k) plans and traditional individual retirement accounts (IRAs), unless the client made after-tax contributions. By contrast, distributions from Roth IRAs are generally tax free if the client is over age 59 ½.

Although pension plans differ in the details, periodic pension payments generally begin at retirement. However, a client can elect to defer payouts by taking a lump sum distribution at retirement and rolling it over into an IRA. Distributions from IRAs and 401(k) plans can generally be deferred past retirement — but not indefinitely.

RMDs. Under the tax law, a client must begin taking required minimum distributions (RMDs) once he or she reaches age 70 ½. The first distribution for the year a client turns 70 ½ is due by April 1 of the following year; distributions for subsequent years must be made by Dec. 31 of each year.

Tax trap: Clients may be tempted to defer the first RMD into the following year, but that will mean doubling up on distributions in that year, which could result in an unusually large tax bill and possibly push the client into a higher tax bracket. Therefore, timing of the first RMD should be considered carefully. What’s more, timing is key for all RMDs. The tax law imposes a 50 percent penalty for failure to take a required distribution.

Social Security income. Many clients may believe that because Social Security taxes were withheld from the paychecks during their working years, the Social Security benefits they receive during retirement are tax free. However, that’s not necessarily the case.

For clients with little or no other income, Social Security benefits will generally escape tax. However, for others, a portion of their Social Security benefits may be subject to tax.

Tax tip: Generally, 85 percent of Social Security benefits will be taxable if a client’s provisional income (modified adjusted gross income plus one-half the Social Security benefits) exceeds a base amount of $44,000 on a joint return or $34,000 on another return ($0 for certain married couples filing separately).

Self-employment income. These days, retirees do not necessarily head for the golf course or the easy chair. Many individuals continue to work past retirement age and many become their own bosses, taking on work as consultants or entrepreneurs. For example, recent data from the Bureau of Labor Statistics reports that about 16 percent of workers age 65 or older are self-employed, compared to less than 10 percent of pre-retirees age 55 to 64.

Like retirement income, self-employment income involves a new set of tax rules. Only the net income from self-employment is taxable — that is, the tax law allows self-employed individuals to deduct a variety of business expenses from gross income. Therefore, clients will need a quick course is what types of expenses are deductible and how to keep track of those expenses. Moreover, when it comes to employment taxes, self-employed individuals are taxed differently from employees. While employees pay only the employee share of Social Security and Medicare taxes, self-employed individuals essentially pay the employer and employee shares (albeit offset by a deduction against self-employment income).

Tax Payments

With retirement, many of your clients will have to deal with estimated taxes for the first time in their lives.

Pension payments and IRA distributions are subject to income tax withholding unless a client directs otherwise. On the other hand, there is no withholding on Social Security benefits unless the client opts to have tax withheld. And, of course, self-employment income is not subject to withholding.

Tax trap: Because a retired client’s income is likely to come from multiple sources, withholding from any given source will not necessarily match up with the client’s tax liability. For example, the default withholding rate for IRA distributions is 10 percent, even though the actual tax on the distribution may be much higher. Therefore, it is important to estimate a client’s actual tax liability on all sources of retirement income and to make estimated tax payments as necessary.

To avoid penalties, estimated tax payments (including withholding) must at least equal the smaller of 90 percent of the current year’s tax liability or 100 percent of the tax for the prior year. Making the right choice can be problematic in the first year of retirement. Basing payments on 100 percent of the prior year’s tax has the benefit of certainty, but may result in overpayment if the client’s income from employment in the prior year was higher than their retirement income. On the other hand, using 90 percent of the current year tax can be difficult since it is easy for a client to misjudge their income in the first year of retirement.

Tax tip: The tax law does provide some leeway for new retirees. The IRS has the authority to waive penalties for underpayment of estimated tax in the first two years of retirement after age 62. The waiver is available if the underpayment is due to reasonable cause and not to willful neglect. To apply for a waiver, the client must file Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts, along with an explanation of the shortfall and document showing the client’s date of retirement.

Monitoring income and tax payments throughout the year can help to avoid a big bill at tax time. However, simply making additional estimated tax payments at year end won’t eliminate penalties. The required payment for the year must be paid ratably in four installments throughout the year, so beefing up a later installment won’t wipe out penalties from earlier in the year.

Tax tip: For clients who are subject to the RMD requirements, there’s a quick fix for this problem. Unless the distribution is needed for living expenses earlier in the year, the client can defer the RMD until late in the year and then request additional withholding from the distribution to cover any estimated tax shortfall. Unlike regular estimated tax payments, amounts withheld from a distribution are treated as paid throughout the year, even if the withholding takes place at year end.

Editor’s note: Get guidance on advising your clients on other life changes with various articles on the Intuit® Tax Pro Center.