8 Common Tax Planning Mistakes Retirees Make — and How to Avoid Them

Retirement Tax Planning Doesn't End When You Stop Working

Many people assume that taxes become simpler once they retire.

In some respects, they do. You may no longer have a paycheck, employer benefits or complicated employment-related tax forms. But retirement can actually create a new set of tax-planning decisions that didn't exist during your working years.

Instead of receiving a predictable paycheck with taxes automatically withheld, retirees may receive income from Social Security, pensions, IRA distributions, Roth conversions, investment accounts, annuities and other sources. The timing and amount of those income sources can have significant tax consequences.

Some mistakes are relatively easy to fix. Others can result in unnecessary taxes, Medicare premium surcharges or penalties that could have been avoided with better planning.

Here are eight of the most common retirement tax-planning mistakes we see—and what retirees can do about them.

1. Not Paying Enough Tax During the Year

The U.S. tax system operates largely on a "pay-as-you-go" basis.

During your working years, this requirement is usually handled automatically. Your employer withholds taxes from your paycheck and sends the money to the government throughout the year.

Retirement can change that.

If you're receiving income from sources where taxes aren't automatically withheld, you may need to make quarterly estimated tax payments. This can become particularly important when you're taking IRA distributions, realizing capital gains or doing Roth conversions.

The estimated tax deadlines generally fall around April 15, June 15, September 15 and January 15 of the following year.

And there's an important distinction between withholding and estimated payments.

Tax withholding is generally treated as though it occurred evenly throughout the year, regardless of when the withholding actually happened. Estimated tax payments, on the other hand, are generally associated with the quarter in which they are paid.

That means waiting until late in the year to make a large estimated payment can potentially result in an underpayment penalty even if you ultimately pay enough tax for the year.

Fortunately, there are safe-harbor rules that can protect taxpayers from underpayment penalties in many situations. Generally, paying at least 90% of the current year's tax liability or 100% of the prior year's liability—110% for certain higher-income taxpayers—can provide protection.

The planning lesson: Don't wait until tax filing season to discover that you should have been making tax payments throughout the year.

2. Missing or Miscalculating Required Minimum Distributions

Required Minimum Distributions, or RMDs, are one of the most important tax issues retirees need to understand.

Once you reach the applicable RMD age, you're generally required to withdraw a certain amount each year from traditional IRAs and other qualifying tax-deferred retirement accounts.

Under the rules described in the source, individuals born before 1960 generally begin RMDs at age 73, while those born in 1960 or later generally begin at age 75.

The calculation is based generally on the prior year-end account balance divided by the applicable IRS life-expectancy factor.

For example, someone with a $500,000 IRA balance at the end of the previous year and a 26.5 life-expectancy factor would have an RMD of approximately $18,868.

Missing an RMD can be expensive. The penalty can be as high as 25% of the amount that should have been distributed, although the penalty can potentially be reduced to 10% when the mistake is corrected within the applicable correction period.

There's also an important coordination issue for retirees with multiple IRAs. The IRS generally allows an individual to satisfy the combined RMD requirement for multiple IRAs by taking the required distribution from one or more of those IRAs. The financial institutions themselves may not know that you've already satisfied the total requirement elsewhere.

The planning lesson: Don't simply rely on each custodian's RMD notice. Make sure someone is looking at your entire retirement account picture.

3. Forgetting to Update Beneficiary Designations

Beneficiary designations are easy to overlook—and potentially one of the most consequential pieces of your financial plan.

IRAs, 401(k)s, life insurance policies and annuities generally have beneficiary designations that determine who receives the assets after your death. Bank and brokerage accounts can also often use transfer-on-death or payable-on-death designations.

The problem is that life changes.

You get married.

You get divorced.

You have children.

Your children become adults.

Your family circumstances change.

But your beneficiary forms may remain exactly as they were when you originally opened the account.

In many situations, the beneficiary designation on the account controls the transfer of the asset—even if your will says something different.

There can also be tax-planning opportunities in deciding which beneficiaries receive which types of accounts.

For example, imagine one child is consistently in a very high tax bracket while another is in a much lower bracket. If you're leaving both traditional and Roth retirement assets, it may be worth considering whether the assets should be divided equally by account or allocated differently to account for the eventual tax consequences to each beneficiary.

This doesn't necessarily mean one child should receive all of the Roth assets and another all of the traditional assets. Fairness, account balances, future tax rates and changing circumstances all matter.

The planning lesson: Review beneficiary designations regularly—and don't assume your will automatically overrides them.

4. Misunderstanding the Roth IRA Five-Year Rules

Roth IRAs are often described as "tax-free retirement accounts."

That's generally true for qualified distributions, but the rules governing Roth withdrawals are more complicated than many retirees realize.

One reason is that there are two separate five-year rules that can apply to Roth IRAs.

The first generally determines when Roth IRA earnings can be withdrawn tax- and penalty-free. It involves both the age requirement and the five-year period associated with the taxpayer's first Roth IRA. Importantly, the five-year clock generally begins with the first year in which any Roth IRA is funded—not separately for each Roth IRA.

The second five-year rule relates specifically to Roth conversions.

When money is converted from a traditional IRA to a Roth IRA, the converted amount itself isn't taxed again when withdrawn. However, a separate five-year rule can determine whether an early withdrawal of a taxable conversion is subject to the 10% early-distribution penalty.

There is another important piece of the puzzle: Roth IRA withdrawals follow ordering rules.

Generally, withdrawals are treated as coming first from regular contributions, then converted amounts and finally earnings. This means someone may be able to withdraw some or all of their original Roth contributions without tax or penalty even when they haven't satisfied the five-year requirements for qualified distributions.

The planning lesson: Before taking money from a Roth IRA, determine whether you're withdrawing contributions, converted funds or earnings. The tax consequences can be very different.

5. Losing Track of IRA Basis

Another frequently misunderstood concept is IRA basis.

Basis generally represents money in a traditional IRA that has already been taxed.

This can happen, for example, when someone makes a nondeductible traditional IRA contribution. Because the taxpayer didn't receive a tax deduction for the contribution, that money shouldn't be taxed again when eventually distributed.

The problem is that basis must be properly tracked—and the IRS doesn't allow you to simply choose to withdraw the after-tax dollars first.

Instead, the IRS generally applies a pro rata rule across all of your traditional, SEP and SIMPLE IRAs.

Consider a simplified example.

Suppose you have $95,000 of pre-tax money in one IRA and contribute $5,000 of after-tax money to another IRA. You now have $100,000 across your IRAs, of which 5% represents after-tax basis.

If you withdraw $5,000, you generally can't designate the entire $5,000 as your after-tax contribution. Instead, approximately 5% of the withdrawal—or $250—would represent tax-free basis, while approximately $4,750 would generally be taxable.

This becomes particularly important when considering backdoor Roth IRA contributions and Roth conversions.

A seemingly simple transaction can produce an unexpected tax bill if existing pre-tax IRA balances aren't taken into account.

The planning lesson: Know whether you have IRA basis, know how much you have, and make sure it is properly documented on your tax returns.

6. Not Making Charitable Giving as Tax-Efficient as Possible

Charitable giving is primarily about supporting causes you care about—not reducing your tax bill.

But if you're already planning to give to charity, there may be ways to structure those gifts more tax-efficiently.

One particularly valuable strategy for retirees is the Qualified Charitable Distribution, or QCD.

Once eligible, an individual with a traditional IRA can instruct the IRA custodian to send money directly from the IRA to a qualifying charity.

A QCD can be particularly useful for someone who has an RMD but doesn't actually need the money to support their lifestyle.

The distribution can satisfy the RMD requirement while generally not being included in the taxpayer's gross income. That distinction is important because income can affect other parts of a retiree's financial picture, including Medicare premiums and the taxation of Social Security.

Another strategy is charitable bunching.

Instead of giving $5,000 to charity every year, for example, a taxpayer might make a larger charitable contribution every few years. The goal is to concentrate deductions into certain years where total itemized deductions may exceed the standard deduction.

Finally, don't overlook documentation.

Charitable deductions generally require appropriate records, including contemporaneous written acknowledgments for qualifying contributions.

The planning lesson: If you're going to give anyway, consider whether the timing and method of your charitable contributions can make the gifts more tax-efficient.

7. Ignoring Modified Adjusted Gross Income

One of the biggest retirement tax-planning mistakes isn't necessarily failing to understand your tax bracket.

It's failing to understand how your Modified Adjusted Gross Income, or MAGI, affects other parts of your financial life.

There isn't just one universal MAGI calculation. Different provisions of the tax code use different definitions.

For retirees, MAGI can affect:

Medicare premium surcharges

Affordable Care Act premium tax credits

The 3.8% Net Investment Income Tax

The amount of Social Security benefits subject to federal income tax

This makes tax planning much more than simply asking, "What tax bracket am I in?"

A retiree might be considering a large Roth conversion because they want to reduce future RMDs. The conversion may accomplish that goal—but it also increases taxable income in the current year.

And if that increased income pushes MAGI above certain thresholds, the consequences can extend beyond the income tax return.

One example is Medicare IRMAA, the income-related adjustment that can increase Medicare premiums. The source specifically highlights the possibility of a large Roth conversion increasing MAGI and consequently increasing Medicare premiums in a later year.

This is why retirement tax planning often requires looking several years ahead.

The planning lesson: Don't evaluate a Roth conversion, capital gain or retirement distribution solely by looking at the immediate tax bill. Consider the effect on your broader MAGI-driven financial costs.

8. Ignoring State Income Taxes

Federal taxes get most of the attention, but state taxes can also influence retirement decisions.

State income-tax rules vary dramatically.

Some states have no individual income tax. Others provide special deductions or exclusions for certain types of retirement income. Still others tax retirement income differently depending on the taxpayer's age, income or source of the income.

Even investment selection can have state-tax implications.

For example, interest from U.S. government obligations such as Treasury securities is generally exempt from state income tax. That can make Treasury bills potentially more attractive on an after-tax basis than a slightly higher-yielding taxable savings account for residents of states with an income tax.

State-specific retirement income exclusions can also create planning opportunities.

The source gives the example of a married couple in New York who could potentially structure IRA distributions between spouses to maximize the state's retirement-income exclusion. The broader lesson is that the timing and ownership of retirement income can matter, not just the total amount withdrawn.

And if you move during retirement, state tax planning becomes even more important.

The planning lesson: Don't assume that a federal tax strategy automatically produces the same result on your state return.

The Bigger Retirement Tax Planning Picture

These eight issues have something important in common.

Most of them are not problems you solve by simply completing your tax return correctly.

They require planning before the transaction occurs.

You can't necessarily undo a Roth conversion after the fact.

You can't always fix an improperly timed estimated tax payment without consequences.

You can't change a beneficiary designation after someone has died.

And once a large retirement distribution has occurred, you may have limited ability to change the resulting tax consequences.

That's why effective retirement tax planning is really about looking forward rather than backward.

A good retirement tax strategy considers not only this year's taxable income, but also future RMDs, Social Security taxation, Medicare premiums, charitable giving, Roth conversions, investment gains, estate planning and state taxes.

A Retirement Tax Plan Should Be Proactive

For retirees, tax planning shouldn't be something that happens once a year when the tax return arrives.

A better approach is to project your income and taxes before the year is over and identify opportunities while there is still time to act.

That might mean deciding how much to convert from a traditional IRA to a Roth IRA.

It might mean determining how much to withdraw from an IRA.

It might mean realizing capital gains—or deliberately postponing them.

It might mean making a Qualified Charitable Distribution instead of taking an RMD into your checking account.

Or it might mean simply making sure your estimated tax payments or withholding are sufficient.

The key is that these decisions are interconnected.

A Roth conversion affects taxable income.

Taxable income affects MAGI.

MAGI can affect Medicare premiums.

Retirement account balances affect future RMDs.

And RMDs can affect future taxable income.

Retirement tax planning is therefore less about finding one clever tax strategy and more about coordinating multiple decisions over time.

The Bottom Line

Retirement doesn't eliminate taxes. In many cases, it changes how you experience them.

Instead of taxes being automatically withheld from a paycheck, retirees may need to coordinate multiple sources of income and make decisions about when and how much to withdraw.

The most costly mistakes are often surprisingly simple: missing an RMD, forgetting to update a beneficiary, misunderstanding Roth withdrawal rules, losing track of IRA basis or failing to consider the effect of a large transaction on Medicare premiums.

The good news is that many of these problems are preventable.

The most effective approach is to look beyond the current year's tax return and consider how today's decisions affect your taxes and financial situation several years into the future.

At 83 Financial, we believe retirement tax planning should be integrated with the rest of your financial plan—not treated as a once-a-year exercise.

The goal isn't simply to pay less tax.

The goal is to make smarter decisions about when you pay taxes, how much you pay, and how those decisions affect the rest of your retirement plan.

This article is intended for educational purposes only and does not constitute individualized tax, legal or investment advice. Tax laws and regulations can change, and individual circumstances vary. Consult your tax and financial professionals before implementing any retirement or tax-planning strategy.