Tax planning for new retirees

Retirement brings lots of changes. Freedom from work. Freedom to do what you want and try new things. But for some new retirees, the biggest adjustment to life after work is how to pay their bills without steady income from a paycheck and how to estimate how much they’ll owe in taxes without the convenience of automatic withholding.

Your newly retired or soon-to-retire clients could probably use a little guidance as to how much in federal and state taxes they should have withheld from their Social Security benefits, annuities, pensions and retirement account distributions. If they don’t withhold enough money to satisfy their tax bill, they could face underpayment penalties. One way to avoid those penalties is through quarterly estimated tax payments.

“This is something new and different for your retired clients,” said Robert Seltzer, an accountant in Los Angeles.

“We run tax projections and recommend withholding amounts from pensions or IRAs,” Seltzer said. “It’s about being proactive in their new phase of life and cementing that relationship by becoming more valuable to your clients.”

Individuals generally have to make estimated tax payments if they expect to owe tax of $1,000 or more when their return is filed. To figure their estimated tax, they must calculate their expected gross income, taxable income, taxes, deductions and credits for the year. See the IRS worksheet accompanying Form 1040-ES, Estimated Tax for Individuals. Clients can use their prior year’s federal tax return as a guide.

If they don’t pay enough tax throughout the year, either through withholding or by making estimated tax payments, they may have to pay a penalty for underpayment of estimated tax. Generally, most taxpayers will avoid this penalty if they owe less than $1,000 after subtracting their withholdings and credits, or if they paid at least 90% of the tax for the current year or 100% of the tax shown on the return for the prior year — whichever is smaller.

Rules are different for higher-income taxpayers. If their adjusted gross income exceeds $75,000 for individuals or $150,000 for married couples filing jointly, they must pay at least 110% of the tax shown on the prior year return, rather than 100%, to avoid an underpayment penalty.

The deadlines for quarterly estimated tax payments for 2022 are April 18, June 15, Sept. 15 and Jan. 17, 2023.

There's an exception for new retirees. If your client retired after reaching age 62 or became disabled during the tax year for which estimated payments were to be made, and the underpayment was due to reasonable cause and not willful neglect, the penalty may be waived.

It’s also important to help retired clients monitor their tax liability as their circumstances change. For example, in the first year of retirement, one spouse may have a salary part of the year and the other spouse may still be working. Consequently, the retired spouse may want to withhold a larger amount of taxes from his or her pension that first year and adjust the withholding in future years.

Other events that could alter a client’s tax withholding throughout retirement may include paying off a mortgage or taking out a new one; one or both spouses starting Social Security benefits; reaching age 72 and taking required minimum distributions from retirement accounts; receiving a large taxable capital gain due to the sale of real estate, mutual funds or stocks; or relocating to a new state with a different income tax rate.

To reduce future taxes, clients may want to consider converting a portion of their traditional retirement accounts to a Roth IRA. Although taxes are due on the converted amount, future withdrawals will be tax-free to both the account holder and heirs. But be aware of short-term tax consequences. A Roth conversion can boost both income taxes in the year of conversion and Medicare premiums two years later.

Another option is to buy permanent life insurance with a long-term care rider that can protect against possible long-term care costs and provide tax-free cash withdrawals during the policyholder’s lifetime as well as tax-free death benefits for heirs.

“If you want the IRS to take the smallest bite possible out of your money, consider these strategies that allow you to convert your tax-deferred money into tax-free money,” said Justin Biance, financial adviser and author of “Designed to Last: Renovate Your Financial House and Retire with Confidence.“

“Being proactive is the key to enjoying your retirement more on your terms,” Biance said.

[Questions about Social Security rules? Find the answers in Mary Beth Franklin’s ebook at Maximizing Social Security Retirement Benefits]