Black Friday already? Where did the year go? The good news: No matter whether you’re retired or on retirement’s doorstep, there’s plenty you can do before the end of 2013 to avoid giving Uncle Sam more than his fair share of your hard-earned income.
Here’s a laundry list of what experts suggest:
Do a dry run
Lest you do something that you might regret later on, consider taking stock of where you are and where you want to be with your tax return. “The last couple of months of the year is an excellent time to do a dry run on your tax return,” said Andrea Blackwelder, president of Wisdom Wealth Strategies. “By November or December, we have a fairly accurate idea of our income and deductions. However, the timing also provides ample time to take advantage of tax-saving strategies, such as last-minute 401(k) contributions, tax harvesting and charitable contributions.”
For newly minted retirees, Blackwelder said, this tax analysis can be incredibly important. “New retirees often fail to fully understand how to manage taxes in retirement,” she said. “If withholding instructions on Social Security, pensions and IRA withdrawals aren’t accurate or sufficient, investors may pay penalties and interest at tax time.”
By doing a dry run and getting sense of what you might owe Uncle Sam, Blackwelder said retirees can clean up any underpaid taxes by using a critical tax strategy provided by IRAs. For instance, IRA account owners may make a distribution and withhold the entire amount for taxes, she said. “The IRS does not consider the payment late, but rather considers it as taxes paid throughout the year,” said Blackwelder.
Review your income strategy
Retirees should evaluate their income strategy each year, taking account all of the changes that may have occurred throughout the year, said Blackwelder. Changes to consider may include important milestones such as turning 59½ (the age at which you can withdraw your retirement money without having to pay Uncle Sam a 10% penalty for early distributions) or 70½ (the age at which you must start withdrawing money from your IRAs and retirement plans — except Roth IRAs), performance of your portfolio, capital gains, tax bracket and tax law changes, and even gifting strategies.
Donate IRA distribution to charity
Speaking of gifting strategies, retirees over age 70½ with charitable gifts to make before the end of the year should remember that they can donate up to $100,000 directly from their IRA to a charity during 2013, said Michael S. Jackson, a partner with Grant Thornton, who also noted that this “law expires this year, again.”
The benefit: “The distribution is not included in income, which raises adjusted gross income (AGI) and potentially limits other deductions or raises (your) overall tax bracket,” said Jackson. Plus, the amount sent to charity will also count toward you required minimum distribution (RMD) for the year.
Other advisers also recommend donating your RMD to a charity. “Since so much of the current tax calculation is based on AGI, the fact that these distributions don’t count toward one’s AGI makes them potentially much more valuable than the charitable deduction even when using appreciated property, said David Mendels, the director of planning at Creative Financial Concepts.
“It is especially valuable for those generous souls whose charitable contributions are already up against the AGI limits” he said. “Since it is not included in AGI it effectively, gives rise to a charitable deduction where there otherwise would not have been one while still meeting the minimum distribution requirements. In both cases it sidesteps the AGI/MAGI problems.”
Read from the Slott Report: Give Your IRA RMD Directly to a Charity by Dec. 31, 2013 to Save Taxes.
Speaking of charity
You might also consider, especially with the stock market trading at all-time highs, gifting highly appreciated securities to a charitable gift trust, said Catherine Gearig, a financial adviser with LifePlan Financial Advisory Group.
For example, let’s say that you have a taxable account at brokerage firm as well as a donor-advised fund or charitable gift trust. You could “shave off the gains” in those investments that have had “significant growth and send them to the charitable gift account,” said Gearig. “Depending upon how much is gifted, this could serve the same purpose as rebalancing the account. Plus, you can deduct the amount gifted on your tax return.”
FYI: Gifting to individuals is on a calendar-year basis and must be done before the end of the year, said Blackwelder.
Speaking of RMDs
And since we’re on the topic of RMDs, don’t forget to take your RMD. This is especially important for those who turned 70½ in the early part of the year. “A RMD may be required to be taken from qualified retirement plans before the end of the year,” she said. And just in case you need some extra motivation: The penalty for not taking the RMD is substantial—50%.
For the record, RMDs begin in the year you turn 70½. Not age 70 and not age 71 but age 70 ½. So who is age 70 ½ in 2013? If you were born from July 1, 1942 up through June 30, 1943 you will be 70 ½ this year. Read more from Ed Slott’s website, Required Minimum Distributions and Age 70½.
Contribute to an HSA
You might have a planning opportunity if you have a high-deductible health insurance plan that allows contributions to a Health Savings Account, or HSA. “HSAs can do double duty as retirement accounts and they have the tax benefits associated with both traditional IRAs and Roth IRAs,” said Jorie Pitt, an associate financial planner at AHC Advisors. “We often recommend that our clients consider making full contributions to their HSAs each year but avoid using the money to pay for health-care needs. Instead, we encourage them to invest the money inside their HSA for retirement.”
By doing so, you get a tax deduction for your contribution and you get tax-deferred or tax-free growth on the contribution and the investment earnings depending on the future use of the money, said Pitt. “If you use the HSA assets to pay for qualified health-care costs now or in the future the contribution and the earnings are withdrawn tax free,” she said. “If, after the age of 65, you use the HSA assets for non-health care costs then the contribution and the earnings were tax-deferred and the money will be taxed upon withdrawal from the HSA.”
By way of background, HSAs were created in 2003 so that individuals covered by high-deductible health plans could receive tax-preferred treatment of money saved for medical expenses, according to the Treasury Department. Generally, an adult who is covered by a high-deductible health plan (and has no other first-dollar coverage) may establish an HSA, according to the Treasury Department.
For 2013, the HSA contribution limit (for employer and employee) is $3,250 for individuals and $6,450 for families. The HSA catch-up contributions (for those age 55 or older) is $1,000. Learn more about the 2013 HSA contribution limits here. And learn more about HSAs at the Treasury Department’s Resource Center website.
Of course, if you decide to contribute to an HSA, make sure that you have money set aside in non-retirement accounts that you can access in case of emergencies. Otherwise, said Pitt, you might find yourself dipping into your HSA or other retirement accounts and possibly face paying a penalty.
Do you have medical deductions?
Speaking of health-related expenses: Beginning in 2013, Jackson said the AGI threshold for those individuals under age 65 rises to 10% of AGI. But for those 65 and older, the 7.5% of AGI threshold remains in place until 2017.
Don’t forget the Medicare deadline
And since we’re talking all things health care, do remember that the Medicare deadline is Dec. 7. Blackwelder those age 65 and older must sign up or face future penalties and higher costs. Changes to existing plans must also be made before the deadline, she said.
You should contact Medicare.gov about three months before your 65th birthday to sign up for Medicare. You can sign up for Medicare even if you do not plan to retire at age 65.
Read Medicare’s Open Enrollment period is Oct. 15 to Dec. 7.
Contribute to your employer-sponsored retirement plan
If income and savings allow for it, Blackwelder suggests diverting a large percentage or all of December’s paycheck toward your company-sponsored retirement plan. “Workers who receive large bonuses in December, or expect the bonus in January, can benefit by contributing as much as possible to their retirement plan before the end of the year,” she said. “The benefit, of course, is that more is saved for retirement and less is immediately taxed.”
Unless you’re already contributing the maximum allowed, don’t forget to increase for 2014 how much you contribute to your company-sponsored retirement plan. Investors using automatic contributions to IRAs and Roth IRAs should also increase the contribution, said Blackwelder. “Often, around the holidays and the New Year, we make resolutions to manage our finances better and save more in the coming year,” she said. “Take advantage of the positive motivation and make the changes. Chances are, you’ll stick with it if the changes are already made.”
Catch up if you can
If you turned 50 in 2013 or if you’re turning the big five-O in 2014, consider the catch-up contribution limits for IRAs and qualified retirement plans. IRAs offer an additional $1,000 contribution catch-up while 401(k)s, 457s, 403bs and other retirement plans allow for $5,500 in catch-up contributions. “Adjust monthly and payroll deductions to get on track for maxing out,” said Blackwelder.
Contribute to a Roth IRA
If your income allows it, Gearig recommends that you contribute the maximum to a Roth IRA. That would be $5,500, or $6,500 for those 50 and older.
If you’re married filing jointly and your modified AGI (MAGI) is less than $178,000 you can contribute up to the limit. Your contribution maximum is reduced if your MAGI is equal to or more than $178,000 but less than $188,000. And you can’t contribute to a Roth IRA if your MAGI $188,000 or more.
If you make too much money and you don’t have a traditional IRA, consider making a nondeductible IRA contribution, then converting it to a Roth, says Gearig. “It’s a way to get around the income restraints,” she said. “Since the tax basis equals the amount contributed, the conversion should be tax free. If you already have a traditional IRA, it won’t work.”
As always, you should consult your tax adviser before trying this at home. Read Backdoor Roth IRA conversion: Tax-free? and, from the IRS, Amount of Roth IRA Contributions That You Can Make For 2013.
Consider a Roth IRA conversion
Roth IRA conversions can be very advantageous for the right taxpayers, notably those who have retired but not yet begun collecting Social Security and/or sizable pensions, according to Pitt. “These taxpayers may have several years of very low taxable income ahead of them,” she said. “In this case, we recommend that (you) consider doing Roth IRA conversions to remove money from (your) tax-deferred IRAs at low tax rates.”
For example, she said a person in the 10% or 15% tax bracket who anticipates being in a higher tax bracket when they begin claiming Social Security may want to consider doing a Roth conversion to the extent that it fills up their current tax bracket. “This can be especially advantageous for taxpayers who still have high deductions,” she said. “In this case, you may even be able to convert to a Roth at no tax liability while you use up room created by your deductions.”
Mendels is also fond of Roth IRA conversions. “The Roth IRA conversion is a perennial favorite of mine,” he said. “While many speak of it as a shelter against tax increases, which it certainly is, it is also a powerful tool even if rates stay the same.”
According to Mendels, many experts point to the tax cost as leading to an immediate decline in one’s “net worth” that can only be made up over time by the resulting tax savings.
That is, of course, true. You have two sides to your personal balance sheet, said Mendels. The Roth IRA conversion reduces the “asset side” because you use this money to pay the taxes due on the Roth IRA conversion but it also reduces the “deferred tax due” on the liability side of your balance sheet. This, said Mendels, “leaves your net worth unaffected and the future tax savings as pure profit.”
Said Mendels: “Only a rather steep decline in tax rates would make it a mistake and, while one can never predict what Congress will do, I don’t know too many people predicting an overall tax cut any time soon.”
And don’t procrastinate when it comes to doing a Roth IRA conversion: It must be done before the end of each calendar year. “However, if you find that the Roth IRA conversion pushed you too far into the next tax bracket you have the option to re-characterize all or a portion of the conversion by the tax filing deadline, including extensions,” Pitt said.
Remember too that once you have done a Roth IRA conversion these funds and earnings on them cannot be accessed for five years from the conversion date without paying a penalty.
According to the IRS, you can convert a traditional IRA to a Roth IRA. The conversion is treated as a rollover, regardless of the conversion method used. Most of the rules for rollovers (Read Rollover From One IRA Into Another) apply to these rollovers.
Speaking of filling up tax brackets, Douglas Gross, a financial adviser with Raymond James Financial, said year’s end is the time to make sure retirees are using up whatever bracket they are now in, especially if pre-RMD and so income is low.
What he does with clients is this: “We figure out their taxable income. Let’s say it is $50,000 and they are married filing jointly. We will then do a Roth conversion of $20,000 to use up the 15% bracket. This is assuming, of course, that once they turn 70½ we know they will always be in the next bracket.”
He too recommends that year-end is the time charitable giving. In his case, he suggests contributing to donor advised fund and offsetting it with a Roth IRA conversion. “It’s tax neutral but it accomplishes two goals: more money in the Roth and more to charity,” said Gross.
Is your mortgage interest deduction worth it?
Determine what the tax benefit is on your mortgage interest compared with what you are earning on your cash, said Jackson. “If retirees are sitting on cash earning 0% interest, it may be prudent to pay down or pay off existing mortgages as long as they have sufficient cash remaining for lifestyle needs,” he said.
Gifts to family members
According to Jackson, you can gift up to $14,000 per year in cash, investments, and/or property without triggering mandatory filing of IRS Gift Tax Form 706 and possible payment of gift taxes to anyone. And married couples can give up to $28,000 to any one person each year.
According to the IRS, the general rule is that any gift is a taxable gift. However, there are many exceptions to this rule, says the IRS. Generally, the following gifts are not taxable gifts: gifts that are not more than the annual exclusion for the calendar year; tuition or medical expenses you pay for someone (the educational and medical exclusions); gifts to your spouse; and gifts to a political organization for its use. Read the IRS’s Gift Tax.
The key benefit in gifting, by the way, is this: Adults can minimize their estate taxes, according to an AXA Equitable primer on the subject.
Also of note. The exclusion amount does not roll from year to year. “It is a use or lose provision,” said Jackson.
Beware the Medicare surtax
Although retirement plan distributions are not subject to the new net investment income tax, Jackson says retirees should know that, since the threshold for this tax is based on a combination of net investment income and AGI, retirement plan distribution can push retirees over those AGI thresholds and subject net investment income to tax.
According to the IRS, the net investment income (NII) tax, which went into effect this year, applies at a rate of 3.8% to certain net investment income of individuals, estates and trusts that have income above the statutory threshold amounts.
Individuals will owe the tax if they have NII and have modified adjusted gross income over the following thresholds:
|Married filing jointly
|Married filing separately
|Head of household (with qualifying person)
|Qualifying widow(er) with dependent child
Read: How to avoid new 3.8% tax on investment income.
Downsize your house
According to Jackson, gains on the sale of primary residences used as such for two of the past five years can be sheltered ($250,000 for singles, $500,000 for married filing joint). “This leaves more money in the seller’s pocket to put down on the next home,” said Jackson.
Read Capital Gains, Losses, Sale of Home.
Don’t move out of state without crunching the numbers
And last but not least, if you have designs on moving to another state, Jackson suggests that you consider the income tax implications on Social Security benefits, retirement plan distributions, as well as estate and inheritance tax rules. Read The most tax-friendly states for retirees.
Robert Powell is editor of Retirement Weekly, published by MarketWatch. Follow his tweets at RJPIII. Got questions about retirement? Get answers. Send Bob an email here.