The Most-Overlooked Tax Breaks for Retirees

For new retirees, it's more important than ever to take full advantage of every tax break available. That's especially true if you're on a fixed income. After all, you have to stretch out your retirement savings to cover the rest of your life. But holding on to your money during retirement is easier said than done. That's why retirees really need to pay close attention to their tax situation.

Unfortunately, though, seniors often miss valuable tax-saving opportunities. In many cases, it's simply because they just don't know about them. Don't let that happen to you — check out these often-overlooked tax breaks for retirees. You could save a bundle!


Bigger Standard Deduction

When you turn 65, the IRS offers you a gift in the form of a larger standard deduction. For example, a single 64-year-old taxpayer can claim a standard deduction of $12,550 on his or her 2021 tax return (it will be $12,950 for 2022 returns). But a single 65-year-old taxpayer will get a $14,250 standard deduction in 2021 ($14,700 in 2022).

The extra $1,700 will make it more likely that you'll take the standard deduction on your 2021 return rather than itemize (the extra amount will be $1,750 for 2022). And, if you do claim the standard deduction, the additional amount will save you over $400 if you're in the 24% income tax bracket.

Couples in which one or both spouses are age 65 or older also get bigger standard deductions than younger taxpayers. If only one spouse is 65 or older, the extra amount for 2021 is $1,350 – $2,700 if both spouses are 65 or older ($1,400 and $2,800, respectively, for 2022). Be sure to take advantage of your age!

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Spousal IRA Contribution

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

Generally, you must have earned income to contribute to an IRA. However, if you're married and your spouse is still working, he or she can generally contribute up to $7,000 a year to a traditional or Roth IRA that you own. (We're assuming that since you're reading about breaks for retirees, you're at least 50 years old.) 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.

There's an important limitation to keep in mind, though. The total combined contributions allowed for the year to your IRA and your spouse's IRA can't exceed $13,000 if only one of you is age 50 or older, or $14,000 if both of you are at least 50 years old.


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. One caveat: You can't claim this deduction if you're 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).

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Tax Credit for Low-Income Seniors

It's easy to miss the special tax credit for low-income elderly (or disabled) people. The credit isn't mentioned at all on the main tax form (Form 1040) or schedules, and the 1040 form instructions only briefly reference it once. It's almost as if the IRS is trying to hide it (naw…they wouldn't do that). But now that we've told you about it, there's no excuse for overlooking this tax break if you're eligible.

To be eligible for the credit, you must be a "qualified individual" and pass two income tests. Generally, you're a qualified individual if, at the end of the tax year:

  • You were age 65 or older; or
  • You were under age 65, you retired on permanent and total disability, and you received taxable disability income.

The first income test is based on your adjusted gross income (AGI). If you file your tax return using the single, head-of-household, or qualifying widow(er) filing status, your AGI must be less than $17,500. If you're married and file a joint return, but only one spouse qualifies for the credit, your AGI can't reach $20,000. Married couples filing jointly must have an AGI below $25,000 if both spouses qualify. Finally, your AGI must be lower than $12,500 if you're married, filing a separate return, and lived apart from your spouse for the entire year.

The second income test is based on the combined total of your non-taxable Social Security, pension, annuity, and disability income. For single, head-of-household, and qualifying widow(er) taxpayers, the combined income must be less than $5,000. The same income limit also applies to joint filers if only one spouse qualifies for the credit. If both spouses on a joint return qualify for the credit, the income limit is $7,500. For married people filing a separate return who didn't live with their spouse during the year, the limit is $3,750.

If, after all of that, you determine that you're eligible for the credit, then you may be able to shave up to $750 off your tax bill if you're single or up to $1,125 if you're married. However, calculating the credit can be complicated. That's why the IRS will calculate the credit amount for you. To take them up on the offer, follow the steps outlined in the instructions to Schedule R (you'll also have to attach Schedule R to your return).


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 to send a check until the following year when your tax return is due, 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 401(k) plan or company pension, the payers will withhold tax — unless you tell them not to. The same goes for withdrawals from a traditional IRA. That's right: In retirement, it's generally up to you whether part of the money will be proactively skimmed off for the IRS.

With 401(k)s, pensions and traditional IRA withdrawals, taxes will be withheld unless you file a Form W-4P to put the kibosh on it. For periodic payments (i.e., payments made in installments at regular intervals over a period of more than one year), withholding is calculated the same way as withholding from wages. When it comes to traditional IRA distributions or other non-periodic payments, withholding will be at a flat 10% rate, unless you request a different rate or block withholding altogether. However, non-IRA distributions that can be rolled over tax-free to an IRA or other eligible retirement plan are generally subject to mandatory 20% withholding — but stay tuned for a way around the 20% withholding.

Things are a little different with Social Security benefits. There will be no withholding unless you specifically ask for it by filing a Form W-4V. You can opt for withholding on Social Security at a 7%, 10%, 12% or 22% rate.

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 make estimated payments if you'll owe more than $1,000 in tax for the year above and beyond what's covered by withholding. Otherwise, you could face a penalty for underpayment of taxes.


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 or other rollover distribution from a company plan, you could fall into a pension-payout trap.

As mentioned earlier, if you take such a distribution, the company is required by law to withhold a flat 20% for the IRS ... even if you simply plan to roll over the money into an IRA. Even if you complete the rollover within the 60 days required by law, the IRS will still hold onto the 20% until you file a tax return for the year and demand a refund. Worse yet, how can you roll over 100% of the lump sum if the IRS is holding onto 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.

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The RMD Workaround

Required minimum distributions (RMDs) weren't required in 2020 — but they're back again for 2021 and beyond. Fortunately, though, retirees taking RMDs 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're 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.

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Give Money to Charity

Once you reach age 70½, there's a tax-friendly way to make charitable donations even if you don't itemize. It's called a qualified charitable distribution (or QCD for short). With a QCD, you can transfer up to $100,000 each year from your traditional IRAs directly to charity. If you're married, your spouse can transfer an additional $100,000 to charity from his or her IRAs. The transfer is excluded from taxable income, and it counts toward your required minimum distribution. That's a win-win! But you can't also claim the tax-free transfer as a charitable deduction on Schedule A if you do itemize.

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Give Money to Your Family

Few Americans have to worry about the federal estate tax. After all, most of us have a credit large enough to permit us to pass up to $11.7 million to heirs in 2021 ($12.06 million in 2022). 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 $15,000 annually to any number of people without worrying about the gift tax ($16,000 in 2022). Your spouse can also give $15,000 to the same person, making the tax-free gift $30,000. For example, if you are married and have three married children and six grandchildren, you and your spouse can give up to $30,000 this year to each of your kids, their spouses and all the grandchildren without even having to file a gift tax return. That's $360,000 in tax-free gifts. Money given under the protection of the exclusion can't be taxed as part of your estate after your death.


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.

Basically, the $250,000/$500,00 exclusion doesn't apply to any profit that is allocable to the time after 2008 that a home is not used as your principal residence. For example, assume you bought a vacation home in 2001, convert it to your principal residence in 2015 and sell it in 2021. 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.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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