The Most-Overlooked Tax Breaks for the Newly Retired

Because federal tax law reaches deep into all aspects of our lives, it’s no surprise that the rules that affect us change as our lives change. This can present opportunities to save or create costly pitfalls to avoid. Being alert to the rolling changes that come at various life stages is the key to holding down your tax bill to the legal minimum.

Bigger Standard Deduction

When you turn 65, the IRS offers a gift in the form of a bigger standard deduction. For 2015 returns, for example, a single 64-year-old gets a standard deduction of $6,300 (it will be the same amount for 2016). A 65-year-old gets $7,850 in 2015 (and $7,850 in 2016).

The extra $1,550 will make it more likely you’ll take the standard deduction rather than itemizing and, if you do, the additional amount will save you almost $400 if you’re in the 25% bracket. Couples in which one or both spouses are age 65 or older also get bigger standard deductions than younger taxpayers. Be sure to take advantage of your age.

Easier Medical Deductions

Until 2017, taxpayers age 65 and older get a break when it comes to deducting medical expenses. Those who itemize get a money-saving deduction to the extent their medical bills exceed 7.5% of adjusted gross income. For younger taxpayers, the AGI threshold is 10%.

Deduct Medicare Premiums
If you become self-employed—say, as a consultant—after you leave your job, you can deduct the premiums you pay for Medicare Part B and Part D, plus the cost of supplemental Medicare (medigap) policies or the cost of a Medicare Advantage plan.

This deduction is available whether or not you itemize and is not subject to the 7.5%-of-AGI test that applies to itemized medical expenses for those age 65 and older. One caveat: You can't claim this deduction if you are eligible to be covered under an employer-subsidized health plan offered by either your employer (if you have retiree medical coverage, for example) or your spouse's employer (if he or she has a job that offers family medical coverage).

Spousal IRA Contribution

Retiring doesn’t necessarily mean an end to the chance to shovel money into an IRA.

If you’re married and your spouse is still working, he or she can contribute up to $6,500 a year to an IRA that you own. (We’re assuming that since you’re reading about breaks for retirees, you’re at least 50 years old.) If you use a traditional IRA, spousal contributions are allowed up to the year you reach age 70 ½. If you use a Roth IRA, there is no age limit. As long as your spouse has enough earned income to fund the contribution to your account (and any deposits to his or her own), this tax shelter’s doors remain open to you.

Timing Tax Payments

Although ours is widely hailed as a “voluntary” tax system, it works best when there is the least opportunity not to volunteer.

So, although we think of April 15 as tax day, taxes are actually due as income is earned, and employers have become the country’s primary tax collectors by withholding taxes from our paychecks. When you retire, you break out of that system: Now it’s up to you to make sure the IRS gets its due when it’s due. If you wait until the following April 15 to send a check, you’re in for a nasty surprise in the form of penalties and interest.

You have two ways to get the job done:

Withholding. Withholding isn’t only for paychecks. If you receive regular payments from a company pension or annuity, the payers will withhold tax. . . unless you tell them not to. The same goes for withdrawals from an IRA. That’s right: In retirement, it’s up to you whether part of the money will be proactively skimmed off for the IRS.

With pensions and annuity payments and traditional IRA withdrawals, taxes will be withheld unless you file a Form W-4P to put the kibosh on it. When it comes to traditional IRA distributions, withholding will be at a flat 10% rate, unless you request a different rate or block withholding all together. Things are topsy-turvy with Social Security benefits. There will be no withholding unless you specifically ask for it . . . by filing a Form W-4V. Withholding isn’t necessarily a bad thing, as it stretches your tax bill over the entire year. It might also make life easier if you would otherwise have to make quarterly estimated tax payments.

Quarterly estimated tax payments. The alternative to withholding is to make quarterly estimated tax payments. You need to if you’ll owe more than $1,000 in tax for the year above and beyond what’s covered by withholding. Otherwise, you’ll face a penalty for underpayment of taxes.

The RMD Workaround

Retirees taking required minimum distributions from their traditional IRAs may have an extra option for meeting the pay-as-you-go demand.

If you don’t need the required distribution to live on during the year, wait until December to take the money. And, ask your IRA sponsor to hold back a big chunk of it for the IRS—enough to cover your estimated tax on both the RMD and your other taxable income as well.

Although estimated tax payments are considered made when you send the checks, amounts withheld from IRA distributions are considered paid throughout the year, even if they are made in a lump sum at year-end. So, if your RMD is more than large enough to cover your tax bill, you can keep your cash safely ensconced in its tax shelter most of the year . . . and still avoid the underpayment penalty.

Avoid the Pension Payout Trap

There’s a menacing exception to the general rule that it’s up to you whether taxes will be withheld from payments from pensions, annuities, IRAs and other retirement plans. If you get a lump-sum payment from a company plan, you could fall into a pension-payout trap.

If you take such a payment, the company is required by law to withhold a flat 20% for the IRS ... even if you simply plan to move the money to an IRA via a tax-free rollover. Even if you complete the rollover within the 60 days required by law, the IRS will still hold on to the 20% until you file a tax return for the year and demand a refund. Worse yet, how can you rollover 100% of the lump sum if the IRS is holding on to 20% of it? Failure to come up with the extra money for the IRA would mean that amount would be considered a taxable distribution—triggering an immediate tax bill, maybe penalties and certainly forever reducing the amount in your IRA tax shelter.

Fortunately, there’s an easy way around that miserable outcome. Simply ask your employer to send the money directly to a rollover IRA. As long as the check is made out to your IRA and not to you personally, there’s no withholding.

Even if you intend to spend some of the money right away, your best bet is still to ask your employer to make the direct IRA transfer. Then, when you withdraw funds from the IRA, it’s up to you whether there will be withholding. 

Tax-Free Profit from a Vacation Home

The rules are clear: To qualify for tax free-profit from the sale of a home, the home must be your principal residence and you must have owned and lived in it for at least two of the five years leading up to the sale. But there is a way to capture tax-free profit from the sale of a former vacation home.

Let’s say you sell the family homestead and cash in on the break that makes up to $250,000 in profit tax-free ($500,000 if you’re married and file jointly). You then move into a vacation home you’ve owned for 25 years. As long as you make that house your principal residence for at least two years, part of the profit on the sale will be tax-free.

To determine what portion of the profit qualifies as tax-free, you need to compare the amount of time you owned the property before 2009 and after you converted it to your principal residence to the amount of time, starting in 2009, that it was used as a vacation home or rental unit. Assume you bought a vacation home in 1998, convert it to your principal residence in 2015 and sell it in 2018. The post-2008 vacation-home use is seven of the 20 years you owned the property. So, 35% (7 ÷ 20) of the profit would be taxable at capital gains rates; the other 65% would qualify for the $250,000/$500,000 exclusion.

 

Give Your Money Away

Few Americans have to worry about the federal estate tax. After all, each of us has a credit large enough to permit us to pass up to $5,450,000 to heirs in 2016. Married couples can pass on double that amount.

But, if the estate tax might be in your future, be sure to take advantage of the annual gift-tax exclusion. This rule lets you give up to $14,000 annually to any number of people without worrying about the gift tax. If you have three married children and each couple has two children, for example, you can give the kids and grandkids a total of $168,000 in 2015 without even having to file a gift tax return. Money given under the protection of the exclusion can’t be taxed as part of your estate after your death.