Five Tax-Saving Strategies for Retirees
by Aleksandra Todorova
Tuesday, March 25, 2008
provided by SmartMoney.com


Paying taxes is never fun. Once you retire, though, this irksome obligation becomes especially painful. Rather than sharing a portion of your earnings, you'll be sending Uncle Sam a piece of the hard-earned savings you were banking on to carry you through your golden years.

It's surprising, then, that tax planning is often overlooked by retirees. "It amazes me how much time people spend picking investments, pouring over stock reports and mutual fund reports, but they don't think about taxes," says Dean Barber, owner and chief investment officer of Barber Financial Group in Lenexa, Kan. "I always tell them, it's not important how much money you make, it's important how much you get to keep."

Take, for example, Social Security income. It's a benefit funded by taxes that you pay throughout your working life, yet once you start receiving it, you could get taxed yet again. "Seniors hate that worse than anything," says Ed Slott, a Rockville Centre, N.Y.-based certified public accountant and author of "Your Complete Retirement Planning Roadmap." The pain could be substantial: Generally speaking, you owe Uncle Sam tax on up to 85% of your Social Security benefits once half of your benefits and the rest of your income — including dividends and interest on taxable investments and withdrawals from tax-deferred accounts, such as IRAs — exceed $34,000 for a single filer or $44,000 for a married couple, filing jointly. (Click here for more details.)

The good news is that some careful planning could help reduce the hit. Here are five smart (and perfectly legal) tax-saving strategies for retirees.

Shelter your IRA from future taxes

For most folks, there's no question that taxes will only go up from here. "Tax rates are on sale now," notes Slott. "They're the lowest we'll see in some time." For retirees who have traditional IRAs, converting to a Roth IRA, which allows you to take money out tax free, is a no-brainer. (For 2008 and 2009, you qualify for a Roth IRA conversion if your adjusted gross income, or AGI, is less than $100,000 in the year of conversion.) The problem is, you'll have to pay taxes now on the full amount that you convert. Depending on the size of your IRA and your tax bracket for the year, that amount could be substantial.

The solution? Reduce your taxable income as much as possible, Barber says. Rather than tapping your 401(k) or IRA, consider meeting your income needs for the year by selling any stocks you owe in a taxable account that have appreciated the least. This will lower your capital gains hit and, ultimately, your taxable income. "If you can live off your principal that puts you essentially in the 0% tax bracket," Barber says. (One snag: The strategy doesn't apply to mutual funds, since they force you into an average cost-per-share tax basis.)

When you make it, spend it

If you have interest earnings from CDs or money-market accounts, consider spending that during the year you earn it, says John Diehl, director of The Hartford's Retirement Solutions Group. "You're paying taxes regardless of whether you use the money or not," he notes. "It's foolish not to use it." If you have a $100,000 CD that earns 5%, for example, spend that $5,000 this year rather than taking an IRA distribution that will only add to your tax liability.

Lessen the hit of required IRA distributions

Once you turn 70 1/2 years old and have to start taking required IRA distributions, you'll start paying taxes on them — on top of any other taxable income you're drawing, as well as any dividends and interest you're earning on your taxable investments. Assuming that you don't need the additional income, you can minimize the added tax hit by shifting some of your taxable investments to tax-deferred accounts, such as tax-free bonds, Barber suggests. While you'll owe tax on those required IRA withdrawals, your overall taxable income will remain steady.

Alternatively, consider using those IRA withdrawals to buy a survivorship life insurance policy for you and your spouse. "On a pair of 70-year-olds you could end up with a $1 million benefit that passes to your heirs tax free," Barber says. Yes, you'll pay tax on the withdrawals, but at the end of the day, your heirs will receive a much larger benefit tax free.

Keep appreciated assets for the kids

It may seem morbidly perverse, but some assets, such as stocks and real estate, get a stepped-up cost basis after you die. What this means is that if your heirs sell the asset after your death, the resulting capital gains tax will be calculated based on the appreciation of those assets since the day of your death, not the day you originally bought it.

If you have stocks or properties that have appreciated significantly over time and you can afford not to sell them, then consider keeping them in your estate while living off other assets, says Michelle Hoesly, president of Northfolk, Va.-based investment advisory firm Resource One. "If you bought a stock 20 years ago, it may be better to pass that along to the kids with its stepped-up basis and pull down money from your IRA, instead," she says. "That's important to people who want to leave a legacy."

Obviously, if stretching your savings to last your lifetime is a challenge, you should let your tax-deferred accounts grow tax free for as long as possible. If you have to sell a home because you need the money, consider looking into a reverse mortgage. For more information, see our guide to reverse mortgages. For more on taxes on inherited investments, read our story here.

Double up your itemized deductions

Many retirees can't claim as many itemized deductions as they could during their working years. In some cases, their mortgages are now nearly paid off and they're paying little or no tax-deductible interest to their lender, or they simply have fewer or no business expenses to write off. Depending on your specific situation, you may want to consider itemizing every other year and taking the standard deduction in between, Hoesly suggests. For example, pay one year's real-estate taxes in January and next year's taxes in December. Then double up your charitable contributions for that year and skip donations for the next. Ignoring your favorite charities for a year may seem heartless, but that tax savings will surely be welcome.

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