The most common tax planning mistakes made by retirees (and how to prevent or fix them)
Last month, I had the honor of presenting a couple of sessions at the annual “Engage” conference for the American Institute of Certified Public Accountants, or AICPA. One session was about implementing a flat fee structure in a financial advisory business. The other was on the most common tax planning mistakes often made by retirees, and how CPAs and advisors can help their clients prevent and/or fix those mistakes.
For many of you who’ve been following this newsletter for a while, you probably already know a lot of these things. But I thought it could be helpful to have all these tax planning “mistakes” put into one article. Hopefully you find it helpful.
And this list of mistakes is by no means comprehensive. Also, it’s my anecdotal experience that was used to decide which ones made the list of being the most common mistakes. There could very well be others that I missed thinking of and didn’t put on the list.
Additionally, each one of these topics could easily be its own deep dive article. As such, I’m going to do my best to try to hit on each topic without getting too deep into the weeds and nuances, but also discuss each one enough to do it some justice.
Anyway, without further ado, let’s get into it. These aren’t in any particular order other than how they came to me when I originally sat down to put the presentation together. Here is what I view as the most common tax planning mistakes made by retirees, and how to prevent or fix them:
Not paying enough tax timely throughout the year, and having underpayment penalties as a result
The U.S. income system is a pay-as-you-go system. Which means you’re supposed to pay tax on taxable income as you receive or earn it. More specifically, the IRS (and most states, in states that have an income tax) breaks down the year into tax quarters.
The first IRS tax quarter is January through March. The second quarter is just April and May. The third quarter is June through August. And the fourth quarter is September through December.
What that means, for example, is that if you receive any taxable income in January through March, you’re supposed to pay to the IRS any tax associated with that income by April 15th, which is the estimated tax deadline for the first quarter.
And then the tax obligation on any income you receive in April or May is supposed to be paid by June 15th, which is the estimated tax deadline for the second quarter. And so on for the third and fourth quarters, where the estimated tax payment deadlines are September 15th and January 15th, respectively.
However, there is more to the story than this. Many people have never made an estimated tax payment and never had to worry about the timing of when taxes were actually paid. That’s because many people had taxes automatically withheld from their paychecks during their working years. In that case, the employer did all the operations of getting tax payments from you and submitting them to the IRS (technically the U.S. Department of Treasury, but I’m just going to continuing saying IRS for consistency sake) throughout the year on your behalf.
Paying tax through withholdings is different than paying taxes through quarterly estimated payments. When having taxes paid through withholdings, such as through payroll deductions from your employer, you don’t really have to think about how to actually get that money to the IRS, or when. Because the employer did that all for you.
But when you instead make estimated payments, you’re the one responsible for figuring out how and when to get the money to the IRS. And that’s typically done by mailing checks to the IRS each quarter or doing an ACH or credit card payment to the IRS via the IRS website.
Another big difference between paying taxes through withholdings vs estimated payments is that there is no timing element to worry about when paying taxes through withholdings, but there is with estimated payments. Recall I said the U.S. tax system is a pay-as-you-go system. And you’re supposed to pay taxes as you recognize taxable income throughout the quarters. And that the amount of tax you pay each quarter should be sufficient to cover the tax obligation on that quarter’s income.
But when instead paying taxes through withholdings, it doesn’t matter when in the year you make the withholdings. As long as you end up withholding enough by December 31 to cover all or most of your tax obligation for the year, you’re good; even if you withhold nothing all year and do a single big fat withholding in December.
Why does the timing of when you pay taxes matter??? Because the IRS will charge you interest on tax underpayments if you don’t pay enough tax throughout the year, when you’re supposed to.
When paying taxes through estimated payments, the IRS will look at what your estimated payment amount should have been each quarter. And if you didn’t pay at least that much by that quarter’s due date, they will start charging you interest every day beyond that until the proper amount is eventually paid. Currently, for the third quarter of 2026, the annual interest rate charged by the IRS on tax underpayments is 7%...not trivial.
And another wrinkle about estimated taxes is that the IRS, by default, assumes you’ll pay your total annual tax obligation in four equal payments throughout the four tax quarters. Thus far I’ve been talking about making tax payments as taxable income is received or earned each quarter. And that’s conceptually correct. But, the IRS’s default treatment is they end up assuming your income was received equally throughout the year. And hence, they expect you to make your estimated tax payment equally throughout the year, in four equal installments.
If, for example, you forgot and didn’t pay anything in the first quarter, and then tried to catch up by paying it in the second quarter, the IRS will end up charging you underpayment interest on the first quarter’s payment you should have made, and they will run the clock on interest on that from April 15th until whenever you eventually pay it.
To further complicate things, if you don’t know what your income is going to be throughout the year and therefore can’t reasonably figure out early in the year what your total tax obligation is going to be and therefore don’t know how much estimated tax you should pay each quarter, there is a way around that. Specifically, if you will have variable, unknown and/or lumpy amounts of taxable income throughout the year, you can wait and figure out your tax obligation quarter-by-quarter and just pay each quarter’s respective estimated payment as needed. But then at the end of the year, you’ll have to fill out Schedule AI of Form 2210 in your tax return to manually tell the IRS how much income you received in each quarter of the year (thus explaining why you made uneven estimated payments each quarter).
On the other hand, when paying taxes for the year via withholdings, you don’t have to worry about when in the year those withholdings are made, like I mentioned above. The IRS treats withholdings as if they were paid equally throughout the year, regardless when in the year you actually do the withholdings.
There is a lot more nuance to the topic of how and when to actually pay income taxes. For example, there are “safe harbors” that can help you avoid underpayment interest, even if it ends up you didn’t pay enough tax throughout the year and owe more tax at tax return time.
Specifically, if you pay through a combination of withholdings and/or equal estimated payments at least 90% of your total tax obligation for the year, you won’t have any underpayment penalties at tax return time.
Or if you pay through a combination of withholdings and/or equal estimated payments at least 100% of what your prior year’s total tax obligation was (or 110% if your AGI is $150k or more), you won’t have any underpayment penalties at tax return time.
There is a lot more nuance to paying taxes and underpayment interest. For more info, below is a YouTube video I did on the topic a few years ago, where I went into much more detail. My takeaway for now is that many people – particularly those who had taxes simply withheld from their paychecks their whole life – don’t realize that when in retirement, you might have to give more thought and consideration to when and how to pay taxes. And that might be a new concept to a lot of folks.
Missing or not taking the correct amount of Required Minimum Distributions (“RMDs”)
The IRS requires people to eventually take money out of their tax-deferred retirement accounts like traditional IRAs and 401(k)s. That’s because all the money in those accounts has not yet been taxed. Contributions to pre-tax accounts are like the name implies: pre-tax. In that sense, all money in pre-tax retirement accounts is not so much an asset as it is not-yet-taxed income. As such, the IRS wants to eventually start getting its cut and doesn’t let people indefinitely defer the recognition of paying tax on that income.
The tax legislation and rules around Required Minimum Distributions, or RMDs, has changed multiple times in the last decade. And I suspect it will change again within the next decade. However, as of the writing of this article, people are required to start taking RMDs from their own accounts in the year they turn 73 if they were born prior to 1960, or in the year they turn 75 if they were born in 1960 or later.
Technically, the first year’s RMD can be deferred until up to April 1 of the following year. But in the second year of RMDs and every year thereafter, the person will have to take the respective year’s RMD by December 31 of that year. This means if you choose to defer your first year RMD into the next year, you’ll then have two RMDs to take that second year; the deferred first year RMD PLUS the second year RMD.
Once a person turns RMD age, they will have to take an RMD every year for the rest of their life, so long as they still have any pre-tax account balances. And there are specific factors that must be applied in determining how much dollar amount of RMD must be taken each year.
Specifically, the factors and the process to apply them and calculate each year’s RMD can be found on the “Free Stuff” section of the Retirement Planning Education website at https://retirementplanningeducation.com/free-stuff
But, in a nutshell, any given year’s RMD is calculated by looking at the account’s prior year-end balance, and dividing it by whatever the appropriate life expectancy factor is for the age the person will be as of December 31 of the year of the RMD.
As an example, assume you will turn 73 this year, in 2026. And your pre-tax IRA had a balance of $500,000 as of December 31, 2025. The prescribed life expectancy factor for you in 2026 is 26.5. Your RMD for 2026 is the $500,000 IRA balance from the end of last year, divided by this year’s life expectancy factor of 26.5, which means you have to distribute no less than $500,000 / 26.5 = $18,867.92 from your IRA in 2026.
It’s common for people not to know they must take RMDs from their retirement accounts. As such, RMDs are often missed. Or, if people do know about RMDs, they might not calculate them correctly and distribute the proper amount. The reason why this could be problematic is because the IRS will impose penalties on the amount of RMDs that were supposed to be taken but weren’t. And those penalties could be sizable.
Prior to a few years ago, the penalty was 50% of the missed RMD amount. Meaning if your RMD for the year was $30,000, for example, and you didn’t take any of it, the IRS could impose a penalty of $15,000, or 50% of $30,000.
However, the penalties around missed RMDs have since been relaxed. Now, the maximum penalty is 25% of the missed amount. Furthermore, the penalty can be reduced to 10% if you catch and rectify the missed RMD within a couple of years of when it was supposed to be taken.
Thankfully, many/most custodians of retirement accounts will do the RMD calculation for you and let you know how much it is. But to add a wrinkle to this, the IRS lets you aggregate together RMDs across all your IRAs. For example, assume you have three IRAs across three different custodians such as Schwab, Fidelity and Vanguard. The IRS lets you take just one distribution from one of those accounts, and that one distribution can satisfy the collective RMD requirement across the three accounts. Basically, the IRS views all your IRAs as one big single IRA.
However, the different custodians don’t communicate or coordinate with each other about your RMDs and distributions across them. For example, if you take a distribution from your Fidelity IRA that satisfies the RMD requirement across all your IRAs, neither Schwab nor Vanguard will know that. And they will likely both notify you that you still have an RMD to take from your account with them. But you don’t have to take any other distributions from those accounts since you would have already satisfied your total annual RMD from your distribution at Fidelity, in this example.
For more information about RMDs from your own accounts (i.e. not inherited accounts; see more about those below), the IRS has a pretty good summary on its website. I recommend starting there to get more info: https://www.irs.gov/retirement-plans/retirement-plan-and-ira-required-minimum-distributions-faqs
The RMD rules around taking distributions from inherited retirement accounts are a completely different ball of wax compared to RMD rules from your own account. Inherited RMD rules are much more complicated and convoluted, unfortunately.
The penalties around missed RMDs from inherited accounts are the same as from your own accounts; 25% on any amounts missed, unless you catch and rectify it within two years, at which point the penalty is only 10%.
A couple of years ago I did the best I could in trying to write a thorough, yet not overly involved, article about RMD rules from inherited accounts. You can find that here: https://tenonfinancial.com/newsletter/required-minimum-distribution-rmd-rules-from-inherited-iras
Having improper beneficiary designations
Qualified retirement accounts like IRAs and 401(k)s don’t pass through a will and probate when the account owner dies. Or at least, they don’t need to pass through a will and probate, as they already have a beneficiary designation and transfer process built into them. As such, it’s important to make sure that beneficiary designations are always up to date on all retirement accounts.
Furthermore, life insurance and annuity contracts pass to heirs/beneficiaries via beneficiary designations within the contracts. These products similarly can completely skip the probate and will process if there are beneficiaries named directly on the contracts.
Additionally, even “normal” non-qualified accounts like bank and brokerage accounts can typically directly pass to heirs – without going through probate or a will - upon the accountholder’s death by naming Payable on Death (“POD”) or Transfer on Death (“TOD”) beneficiaries on the accounts.
You might be asking why I’m including beneficiary designations as a tax planning mistake here in this article. That’s because there could potentially be tax planning implications to not having optimized beneficiary designations on your accounts.
But that aside, there are potentially even bigger non-tax related implications to not having your beneficiary designations up to date. The classic example is having a life insurance policy you bought when you were married to a previous spouse. At the time, you might have named that spouse as the beneficiary of the policy’s death benefit payout. And then fast forward ten years later; assume you’ve since gotten divorced from that prior spouse and have remarried. Your intention/expectation now might be that your new spouse should be the beneficiary of all your accounts and life insurance policies. However, unless you consciously updated your beneficiary designation on your life insurance to take off your old spouse and put on your new spouse, your old spouse will get the death benefit if/when you die.
And the same would be true if you have an IRA and named your original/ex-spouse as the beneficiary of the account. Unless you update the beneficiary designation on the IRA to remove your old spouse and put on your new spouse, it’s your old spouse who’ll get the account upon your passing.
Furthermore, beneficiary designations on retirement accounts and insurance products trump whatever your will might say. Even if you redid your will upon getting remarried to say your new spouse is the one to receive all your accounts, insurance proceeds, possessions, etc., that wouldn’t override the fact that your insurance policy and IRA in our example still have your ex-spouse listed as the beneficiary. So make sure you routinely review and update your beneficiaries on your retirement accounts, insurance policies, annuities, and bank & brokerage accounts.
Anyway, back to the tax planning aspect of beneficiaries. There could be some potential optimization techniques to help make wealth transfer upon your passing as tax-efficient as possible.
For example, assume all your assets are going to go to your two children, one of whom is an esteemed brain surgeon and will always likely be in the top tax bracket, and the other is a starving artist and will likely always be in a lower income bracket. If you have a mix of pre-tax and Roth retirement accounts (where heirs will have to pay income tax on any pre-tax accounts they inherit from you, but won’t have to pay income tax on any Roth accounts they inherit from you), it could make sense to consider naming different beneficiaries on your various accounts, instead of just naming both kids 50/50.
That’s because it would be better for the surgeon child to receive Roth money and the artist child to receive the pre-tax money. For example, if we assume the surgeon will always be in the top federal tax bracket of 37%, and the artist is only in the 12% bracket, a lot more money will be lost to income taxes if the surgeon inherits the pre-tax account and has to pay tax on it at 37%, as opposed to the artist inheriting it and only having to pay 12% tax on it.
This tax optimization thing is more nuanced than this, and often hard to actually implement fairly and properly. And that’s because you might want each kid to end up getting the same and for things to be as equitable as possible. But what if your pre-tax IRA is four or five times larger than your Roth IRA? You wouldn’t then want to leave 100% of your IRA the artist and 100% of the Roth IRA to the surgeon, because the dollar amounts they’d each get would be very different. But then what’s correct split of beneficiaries of each account to try to ensure each kid ends up with about the same dollar amount of inheritance, net of whatever their tax bill will be on it??? That’s much more difficult to figure out. Especially since the accounts could fluctuate in value over time before you pass. So you might have to keep tweaking your beneficiary split percentages throughout the years. Which could be clunky and cumbersome to have to do repeatedly.
While the difficulty of getting a beneficiary designation plan as tax-optimized as possible is really hard to do “right,” that doesn’t mean there isn’t at least food for thought and general directionality to keep in mind when deciding who should be named as beneficiaries of your various assets.
I unfortunately don’t have any other content I’ve done about this topic, so I have nothing else to share here. But this has given me a good idea of a topic to write about in more detail some point in the future!
Not understanding and properly applying Roth account withdrawal rules
One of the most misunderstood topics I see are with the two different 5-year rules around Roth accounts. And notice I said Roth “accounts,” and not just Roth IRAs. For the most part, these rules apply the same whether the Roth account we’re talking about is a Roth IRA, a Roth 401(k), a Roth 403(b), etc. But for simplicity sake and trying to not make this article longer than it already is, I’m going to just discuss these rules in the context of Roth IRAs.
Many people know there is a 5-year rule around taking money out of Roth IRAs. And some people know there is a 5-year rule that could apply to doing Roth conversions. But many people don’t know those two rules are separate and distinct. Furthermore, many don’t fully understand the nuance and application of each rule. As such, that often leads to people not taking Roth IRA distributions when they could or should. And it also leads to people taking Roth IRA distributions when they ideally shouldn’t have.
The first and more overarching 5-year rule applies to when you can take out earnings from a Roth IRA, without tax or penalty.
This is a two-pronged test where the first prong is that your first Roth IRA needs to have been funded at least five years prior. Notice I said your “first” Roth IRA, and not just “your” or “the” Roth IRA. Regardless whether you have always had only one Roth IRA, or you have 20, the 5-year clock started in the year you first got money into any Roth IRA in your name.
That initial funding could have been through a direct contribution, a conversion or a rollover from a non-IRA employer plan like a 401(k). Furthermore, the 5-year clock starts January 1 of that first year. For example, if you’ve never had a Roth IRA before and you open one now, in July 2026, and put fifty bucks into you, you will have started the clock effective January 1, 2026…six months before you actually put the money in. Which means your 5-year clock will be satisfied at the end of December 31, 2030.
The other of the two prongs has a few different ways it can be met. But the most common is that you’re at least 59 ½ years old.
Let’s assume you meet these two prongs, what does that actually mean??? It means that any and all distributions you take out of any and all of your Roth IRAs (again regardless how many you have) will be “qualified.” And that means no taxes or penalties on anything you take out, for the rest of your life. Furthermore, any amounts you take out will not only not be taxable, but they won’t even be included on your tax return as gross income. And therefore they won’t potentially trigger other gross income-driven things like Medicare premium surcharges, the Net Investment Income Tax, loss of eligibility for Affordable Care Act premium tax credits, etc. (see the latter section of this article about Modified Adjusted Gross Income, or MAGI).
If you’ve met these two prongs (i.e. your first Roth IRA was funded at least five years ago AND you’re at least 59 ½), you no longer have to worry about any rules, restrictions or timing elements to taking money out of any of your Roth IRAs. Every cent you take out will be tax and penalty-free. Period.
However, even if you haven’t met one or both of the two prongs, there could still be ways you can take money out of a Roth IRA without tax and/or penalty.
That’s because there are special ordering rules with taking money out of Roth IRAs. Specifically, every dollar you take out of a Roth IRA is assumed to be you taking out monies you directly contributed. And contributions are able to be taken out at any time, with no tax or penalty. That’s because there is no tax break or tax deferral on contributing money to a Roth IRA. Hence, there is no tax, penalty or restriction on taking it out.
After you’ve taken out all of your contributions from a Roth IRA, the ordering rules then assume you’re taking out amounts you converted, if any. And taking out converted amounts may or may not be taxable (it’s tricky, and partially related to the second 5-year rule discussed below).
After you’ve taken out all of your contributions and conversions, only then do the ordering rules assume you’re taking out earnings. And earnings might be taxable and/or subject to penalty, depending on whether you’ve met one or both of the two prongs mentioned above.
Let’s do a quick example. Assume you’re 48 years old and just started your first Roth IRA two years ago, when you contributed $5,000 into it. It’s since grown to $7,000. You haven’t met either of the two prongs yet; your first Roth IRA isn’t yet five years old, and you’re not yet 59 ½. But that doesn’t mean you can’t take anything out. Due to the ordering rules, you can take out up to $5,000 at any time, with no tax or penalty. That’s because the first $5,000 you take out is simply you taking out your original contribution.
But if you were to take out all $7,000, then you’d have to pay tax AND 10% early withdrawal penalty on the additional $2,000. Since the $2,000 is earnings and you haven’t met either of the two prongs yet, that $2,000 is both taxable AND subject to the early withdrawal penalty.
The second of the two Roth IRA 5-year rules pertains only to doing Roth conversions; transferring/converting money from a traditional IRA to a Roth IRA. Furthermore, it only applies if the conversion was taxable. Wait, what???
This is where it gets tricky. If the amount you converted was already taxed, then the conversion isn’t taxable. And then you can take out the amount converted at any time, with no tax or penalty. But if the amount converted was taxable, then you can’t take out the amount converted, without penalty, until you’re at least 59 ½, or until it’s been five years since the conversion; whichever comes first.
There will never be tax on taking out from a Roth IRA an amount that was converted. That’s because that money was already taxed, so it won’t be taxed again. But the amount could be subject to the 10% early withdrawal penalty. And that’s specifically what this second 5-year rule is meant to figure out; will the penalty apply to taking out the amount converted.
This is another topic that is deceptively complicated and has more nuance than I want to get into in this article. But for a deeper dive, below is a YouTube video I did on the topic over five years ago. The video is clearly old, but the rules and explanations still apply just the same.
Not understanding IRA “basis” and the pro rata rule
Traditional tax-deferred accounts can sometimes have after-tax money in them, where such after-tax money is known as “basis.” This could be problematic for folks who aren’t aware they have some already-taxed money in their otherwise pre-tax accounts, and then end up paying tax on that money again whenever they eventually take it out of the account. As such, it’s important to be aware of the existence of basis, and to properly track it so you can accurately account for the taxability of your distributions out of that account.
Basis can apply in any type of tax-deferred accounts, not just IRAs. But again for simplicity, I’m going to just refer to IRAs here.
Whenever you make a non-deductible contribution to a traditional IRA, you create basis in your IRA. Generally speaking, contributions to traditional IRAs are normally tax-deferred, meaning you get a current year tax reduction on the amount of the contribution. And then you’re eventually taxed on that money whenever you later take it out.
But if your income is too high, you might not be able to defer taxation on the contributions to your IRA. You can still make a contribution, but you can’t get a current year tax break or deferral for it. That is when you create basis, as the amount contributed is after-tax.
Where things get complicated with basis is tracking it and then having to prorate any distributions or conversions you do out of that IRA. Furthermore, the IRS makes you aggregate together ALL of your IRAs for purposes of doing the pro rata calculation.
Also, when doing a distribution or conversion out of an IRA when you have basis, you can’t cherry pick just the basis and distribute or convert that. Every dollar of distribution or conversion will be prorated parts consisting of tax-free removal of your basis and taxable removal of pre-tax money from the account.
For example, assume you have a rollover IRA with $95,000 in it. And all of that is not yet taxed money. And then you open a new IRA and contribute $5,000 of after-tax money in it. You now have two IRAs, totaling $100,000. If you were to take $5,000 out of the new IRA, you might think that’s not going to be taxable because you already paid tax on that $5,000. But recall I said the IRS makes you aggregate together all your IRAs and functionally treat them as one.
In this example, $5,000, or 5%, of your total IRA balances is already-taxed money. The other $95,000, or 95%, hasn’t yet been taxed. As such, any distribution or conversion you do will be 5% tax-free and 95% taxable. Which means if you were to take $5,000 out of that new IRA, 95% of it, or $4,750, will be taxable. Only $250, or 5% of it, would be deemed to be removing basis, and therefore tax-free.
Again, there is a lot more to this than what I touched on above. But lest you fear I’m leaving you hanging, I have yet another lengthy YouTube video discussing the topic in much greater detail:
Not being as tax-efficient as possible with charitable giving
When giving to charity, there could be ways to make it more tax-efficient for you. Not that tax considerations should drive whether you give to charity or not, or how much you give. But if you are charitably inclined and desire to give a certain amount, there could be ways to do so to maximize the potential tax benefits for yourself.
One such example is for anyone who’s at least 70 ½ years old and has an IRA with pre-tax money in it. In this case, you’re able to do a Qualified Charitable Distribution, or QCD, to a charity. A QCD is when you instruct the custodian of your IRA to directly send a cash donation from your IRA to a qualifying charity.
The benefits of giving cash to a charity via a QCD instead of just a normal cash donation from your bank account, for example, is that QCDs reduce your pre-tax IRA balance and are not included in your gross income. Which means they aren’t taxable, either. Additionally, QCDs can satisfy RMDs. As such, if you have to take an RMD and don’t actually need the money, a QCD could be a great way to satisfy the RMD and have the distribution not be taxable.
By reducing your IRA balance, that means lower RMDs and less taxable distributions to have to take out down the road. Furthermore, since QCDs aren’t included in gross income, they don’t increase your Modified Adjusted Gross Income, or MAGI. And that means QCDs won’t impact other things that are driven off of MAGI, such as potential Medicare premium surcharges, Affordable Care Act (“ACA”) premium tax credit eligibility, how much of your Social Security is taxable, etc. See the latter section of this newsletter for more info about MAGI.
Another potential way to maximize the tax benefits of charitable donations is to consider “bunching” donations. Considering how large the standard deductions are currently, many people aren’t able to itemize their deductions, which means any charitable donations they make might not have any direct tax benefit for them.
For example, assume you’re single and donate $5,000 per year to charities. And assume your only other itemizable deduction for the year is $6,000 of property tax and $4,000 of state and local taxes. In total, your itemized deductions would be $15,000, which isn’t larger than your standard deduction.
You could consider bunching donations such that you give $15,000 every three years (for example), instead of $5,000 every year. That way, in the years of the bunched donations, you’ll then have $25,000 of itemizable donations. And that is currently larger than what your standard deduction is, so you’ll end up having lower taxable income as a result.
Another somewhat common tax “mistake” is not receiving or keeping proper documentation of all donations. Any time you donate to a qualified charity, you’re supposed to receive “contemporaneous written acknowledgement” of the donation from the charity. In the case of donating cash, charities are usually good about sending a letter or receipt type of acknowledgement to you for the donation. But when donating physical goods, many places don’t give an acknowledgement detailing or itemizing what they received from you. If you claim all those items as a deduction, and the IRS were to ever question you on the validity of those donations, the deductions will be disallowed if you can’t provide proper documentation and the contemporaneous written acknowledgement from the receiving charity.
The takeaway to this section is to be aware of the ways in which you can potentially be more tax-efficient with your charitable giving. And be sure to receive and keep proper documentation for all donations! For more info, see the links below for a previous newsletter and YouTube video I did on these topics.
https://tenonfinancial.com/newsletter/how-to-donate-to-charities-tax-efficiently
Not managing Modified Adjusted Gross Income (“MAGI”)
There are many different definitions of Modified Adjusted Gross Income, or MAGI, used throughout the tax code. It’s important to be aware of some of the more common ones as they relate to retirement and retirement planning.
As the name implies, Modified Adjusted Gross Income is the Adjusted Gross Income from your tax return, but Modified to add or delete certain items. There are at least a dozen different MAGI’s that I’m aware of, but the ones you’re most likely to come across are the ones that determine:
- How much Medicare premium surcharge, if any, you have to pay
- Your eligibility for premium tax credit subsidies if you’re on Affordable Care Act (“ACA”) health insurance before being eligible for Medicare at age 65
- Whether or not the 3.8% Net Investment Income Tax (“NIIT) will apply to your sources of passive investment income
- How much of your Social Security will be taxable
Sometimes, your MAGI is going to be whatever it’s going to be, and you will have no control over it. In that case, it might trigger off some unwanted outcomes related to the above few points. Such has having to pay more for Medicare.
However, many times you will find you have at least some ability to control how much of your income is taxable, and therefore what your MAGI is going to be. And with some good planning and projections, you can potentially minimize or avoid some unwanted MAGI-driven things.
This will involve understanding the different MAGI’s that pertain to you, how they’re calculated, and how to try to control the elements of your tax return that impact them. And it will often require doing thorough income/tax projections, which means you’ll have to have a really good handle on all of the items of information on your tax return and how to potentially control them, to the extent possible. Such as taking less distributions from pre-tax retirement accounts. Or holding off on realizing capital gains in a brokerage account until a future tax year. Or making MAGI-reducing contributions to things like Health Savings Accounts (“HSAs”) or IRAs, if/where possible.
One of the most common examples I see of people not being aware of managing MAGI – and it resulting in an unwanted surprise – is doing a large Roth conversion and it spiking MAGI. Most people know that doing a large conversion will be a taxable event in the year of the conversion. But what ends up being a surprise is having to pay potentially hundreds of dollars a month more for Medicare two years after the year of the conversion, as a result of the spike in MAGI from the conversion.
For more information about Medicare surcharges, check out my prior newsletter about it here: https://tenonfinancial.com/newsletter/if-youre-63-or-older-make-sure-you-get-to-know-irmaa
And for more information about the common MAGI’s in retirement, check out a YouTube video I did about this topic:
Not planning for state-specific income tax considerations
When thinking of taxes and tax planning, many people obviously consider and plan for the federal tax implications of doing (or not doing) something. However, many folks don’t give proper focus to state income tax considerations, where applicable.
Generally speaking, federal tax impacts will be larger than state tax impacts. But nonetheless, there could potentially be some state-level optimizing and planning to consider that could impact how and when you do something. As such, state income tax considerations and planning need to come into play.
This is even true for financial advisors, who might work with people in numerous states. While federal tax planning and implications apply the same to everyone regardless of what state they’re in, the state-specific things will obviously vary. And each state could have very different nuances and twists to consider as it relates to income tax (at least for those states that have an income tax). With this in mind, it’s important for advisors to be as well-versed as possible in the state-specific tax items of the states in which their clients live.
Some things apply equally to all states, such as the fact that interest received from U.S. government debt obligations like U.S. Treasuries is income tax-free in all states. And this could lead to a planning opportunity when deciding what types of cash and cash equivalent investments to use. For example, maybe the interest rate someone can get in a high yield savings account is slightly higher than the interest someone could get if they bought a Treasury Bill. But, the interest from the savings account will likely be taxable at the state level, whereas the Treasury Bill interest will not. Therefore, depending what the person’s state income tax rate is, the net-of-tax interest on the Treasury Bill could be higher than that of the savings account.
Then there are some tax planning things that are state-specific and can different across states. For example, some states have a partial retiree income exclusion provision such that up to a certain dollar amount of retirement income could be tax-free at the state level. One such case is New York, where people over 59 ½ can excluded up to $20,000 of retirement income from taxability at the state level.
A sample planning opportunity in this case would be as follows: assume a married couple lives in New York, and they’re both in their 60s and retired. They want to take a total $40,000 IRA distribution for the year. If just one of the spouses were to take the full $40,000 distribution, then that spouse would be able to exclude $20,000 of it from their New York state tax return, but the other $20,000 would be included as taxable. If, on the other hand, the distributions were to be split up such that each spouse took a $20,000 distribution from their respective IRAs, then both of those distributions would be excluded on their state tax return, making the full $40,000 of distributions ultimately tax-free at the state level. This minor change in how much distribution each person takes could lead to a tax savings of roughly a thousand dollars, if not more, depending what tax bracket the couple is in.
For consumers, the best way to be aware of state-specific tax planning opportunities is to research the tax rules as much as possible in their state. For advisors, learning everything there is to know is more challenging as it could involve having to learn and research tax nuances of multiple states. But there’s no shortcut to putting in the work and doing the learning.
Depending on the planning opportunity that was missed or done incorrectly, it might be possible to undo it, fix it, etc. As in the case of the IRA distribution example above, you could potentially use the 60-day indirect rollover rules to undo the single $40,000 distribution and instead do two different $20,000 distributions.
Or if there are things that you don’t have to redo or undo, per se, but could benefit from by amending your state tax return, that’s another way to potentially “fix” a tax planning mistake. For example, states often have their own unique forms of deductions or credits that are different from the federal return. If you realize you mistakenly left off a deduction or credit that you could have taken on your state return but didn’t, you can potentially amend your state return. Generally speaking, most states let you amend returns going back up to three years. But check with your particular state to see what the rules are on amending returns.
I unfortunately don’t have any other material or content to share as it relates to state tax planning information. But if I did, I’d link to it here!
That’s it for this month’s article. I hope you found it helpful. I know I tried to cram a lot into this one. And I know that each section isn’t nearly as comprehensive as it could be. And, as you can probably tell, I started to run out of gas toward the end and the last few topics were much shorter than the first few… Nonetheless, I hope this article at least gave some good food for thought, and the links to the additional content sources prove valuable.
Disclaimer:
None of the information provided herein is intended as investment, tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement, of any company, security, fund, or other securities or non-securities offering. The information should not be relied upon for purposes of transacting securities or other investments. Your use of the information is at your sole risk. The content is provided ‘as is’ and without warranties, either expressed or implied. Tenon Financial LLC does not promise or guarantee any income or particular result from your use of the information contained herein. Under no circumstances will Tenon Financial LLC be liable for any loss or damage caused by your reliance on the information contained herein. It is your responsibility to evaluate any information, opinion, or other content contained.