Retirement is life changing in so many ways, and it is different for different people. For some it means downsizing and relocating. For others it means reduced work schedules, ceasing work entirely, changing careers or starting businesses. As people age, for many there is an increased need for medical care and other assistance. Each of these areas entails tax rules. Here are some of the key tax rules for retirees.
1. Social Security Benefits
Social Security benefits can begin for an eligible worker at age 62. The current full retirement age, which is the age at which benefits are not reduced, is 66. The full retirement age will rise to 67 for those born in 1960 and later. If benefits are delayed past full retirement age, additional credits can be earned to age 70. Spouses, divorced spouses, and widow(er)s may be eligible to collect on a worker’s benefits at an earlier age. Regardless of the age at which benefits commence, the same tax rules apply.
For federal income tax purposes, Social Security benefits may be tax free or includible in gross income at 50% or 85% (Code Sec. 86). High-income taxpayers can assume that they are subject to the 85% inclusion amount; others may have to do calculations to determine whether benefits are tax-free or their applicable percentage.
If “income” (defined below) is no more than a base amount, benefits are tax-free. “Income” for this purpose is income that is taxed, such as wages, interest, ordinary dividends, capital gain distributions, and pensions, tax-exempt interest, and one-half of Social Security benefits. The base amount is $25,000 if single, head of household, qualifying widow(er), or married person filing separately who lived apart from his/her spouse for the entire year; $32,000 if married filing jointly, and zero if married filing separately but lived with the spouse for any part of the year. If “income” is more than the base amount but not more than $34,000 if single, head of household, qualifying widow(er), or married person filing separately who lived apart from his/her spouse for the entire year ($44,000 for joint filers), then 50% of benefits are includible in gross income. If “income” is more than $34,000 ($44,000), then 85% of benefits are includible in gross income.
For state income tax purposes, the rules may be different. Twenty-eight states and the District of Columbia fully exempt Social Security benefits from their income taxes. A handful of other states have different income thresholds for taxing benefits than the income thresholds for federal income tax purposes.
2. Health Care
Health care costs are a significant outlay in retirement. According to one report (https://www.hvsfinancial. com/PublicFiles/Data_Release.pdf), a healthy 65-year old couple retiring this year can expect to pay nearly $400,000 over the remainder of their lives for Medicare Parts B and D, a supplemental insurance policy, dental and vision care, and out-of-pocket expenses. Those with chronic health issues will pay much more.
Medicare premiums and other unreimbursed medical expenses are a deductible medical expense (Code Sec. 213). In 2016, those age 65 and older by year-end can deduct itemized medical expenses to the extent they exceed 7.5% of adjusted gross income (AGI). Starting in 2017 and later, the AGI threshold rises to 10% (the same as the threshold for younger taxpayers).
If a taxpayer is a “self-employed individual” (which for purposes of the self-employed health insurance deduction includes sole proprietors, partners, limited liability company members, and more-than-2% S corporation shareholders), Medicare premiums are deductible in full as an adjustment to gross income (Chief Council Advice Memorandum 201228037).
High-income taxpayers pay an additional Medicare premium (a surcharge), the amount of which varies with modified adjusted gross income (MAGI) two years prior to the current year. Thus, Medicare premiums for 2017 will be determined by MAGI on 2015 returns that have just been filed. For 2016, the surcharge applies for singles and married persons filing separately with MAGI over $85,000 ($170,000 for joint filers) (https:// www.medicare.gov/your-medicare-costs/part-b-costs/part-bcosts. html).
Health Savings Accounts. Once an individual reaches age 65 and can begin Medicare, contributions to a Health Savings Account (HSA) are no longer permissible (Code Sec. 223(b) (7)). However, those who have existing accounts can tap into them at any time. Withdrawals to cover qualified medical costs are tax free; withdrawals for any other purpose are taxable. Beginning at the age 65 when Medicare begins, the 20% penalty on nonqualified withdrawals no longer applies (Code Sec. 223(f) (4)(C)). Thus, funds can be used for a nonmedical purpose on a penalty-free basis.
Long-term Care. The cost of longterm care for chronic illnesses (e.g., custodial care for those who cannot manage daily living tasks on their own or who need supervision because of cognitive impairment) is not covered by Medicare. Those who lack recourses may qualify on a needs basis for Medicaid to pay for long-term care. Those who cannot qualify or cannot easily pay for this care out-ofpocket may carry long-term care insurance for this purpose.
For federal income taxes, the amount of premiums for long-term care insurance that can be treated as a deductible medical expense is capped by age. In 2016, those who are more than 60 years old but not more than 70, the dollar limit is $3,900; for those 70 and older the limit is $4,870 (Rev. Proc. 2015-53, IRB 2015- 443, 615).
For state income taxes, different rules may apply. For example, in New York, 20% of long-term care insurance premiums are a tax credit against state income taxes (https://www.tax.ny.gov/pdf/current_ forms/it/it249i.pdf).
3. Retirement Plans and IRAs
Many spend a lifetime of building up retirement savings in qualified retirement plans, such as 401(k)s and 403(b)s, and in IRAs. Those who made considerable contributions and invested wisely have a nice nest egg for retirement. Those with defined benefit (pension) plans usually begin to receive benefits at age 65 or other age specified in the plan. While there is no requirement to take lifetime withdrawals from Roth IRAs or designated Roth accounts, other tax-advantaged savings plans must adhere to distribution requirements.
Early Distributions. Funds can be withdrawn in any amount at any time. However, withdrawals before a certain age may trigger a 10% early distribution penalty (Code Sec. 72). Funds from a qualified plan can be withdrawn penalty free starting at age 55 if the taxpayer is separated from service (e.g., is terminated or retires from the job). For IRAs, as well as for qualified retirement plans for selfemployed individuals, the early distribution penalty applies for withdrawals prior to age 59-1/2 unless a special penalty exception (e.g., disability, paying education costs or first-time home buying expenses) applies. Thus, someone retiring at age 65 can withdraw funds from 401(k) accounts and IRAs penalty free; the withdrawals are fully taxable unless they relate to after-tax contributions.
Required Minimum Distributions (RMD). Generally, you must begin to draw down these retirement savings starting in the year of reaching age 70-1/2. The first RMD can be postponed to April 1 of the following year, but this means taking two RMDs in the same year: the first RMD by April 1 and the second RMD by December 31. Also, if someone is still working for a company and does not own more than 5% of the business, he or she can postpone distributions from the company’s plan until actual retirement even though after age 70-1/2.
The rules on figuring distributions and strategies for minimizing taxes on the distributions are not simple, and beyond the scope of this article. More details can be found in IRS Publication 590-B and Reg. Sec. 1.401(a)(9)-5.
Those who are age 70-1/2 or older can transfer tax free up to $100,000 annually from an IRA directly to a public charity; these are called qualified charitable distributions (QCDs) (Code Sec. 408(d)(8)). The amount transferred is applied toward RMDs for IRAs for the year. This rule does not apply to SEPIRAs, SIMPLE-IRA, or qualified retirement plans.
4. Selling a Residence
For many seniors, retirement means downsizing. This entails the sale of a principal residence. Gain on the sale of a principal residence up to $250,000 ($500,000 on a joint return) is tax free (Code Sec. 121).
To qualify for this exclusion, you must have owned and used your home as your principal residence for a period aggregating at least two years out of the five years prior to its date of sale. The ownership and use tests can be met during different two-year periods. However, you must meet both tests during the fiveyear period ending on the date of the sale. Generally, you cannot use the exclusion if you excluded the gain from the sale of another home during the two-year period prior to the sale of your home.
Expensive Homes. If gain is more than the applicable exclusion amount, any additional gain is subject to the capital gains tax (15% for most taxpayers; 20% for those in the top income tax bracket). What’s more, there may be different state or local tax rules. For example, in New York, there’s a so-called “mansion tax” of 1% on sales of homes of $1 million or more (https://www.tax.ny.gov/pdf/publications/ real_estate/pub577.pdf).
Also, for a high-income taxpayer (income over $200,000 for singles, $250,000 for joint filers, and $125,000 for married persons filing separately), the additional capital gain is subject to the net investment income (NII) tax (Code Sec. 1411). This can mean an additional 3.8% tax on the gain that is not excluded (the amount of the NII tax depends on net investment income and modified adjusted gross income over the income thresholds listed above).
At retirement, some people move for a variety of reasons: to be in a warmer climate, to be closer to children and grandchildren, to obtain a lower cost of living. Whatever the reason, when relocating across state lines, consider the impact of state and local taxes. These include state income taxes, sales taxes, death taxes, and if owning a home, property taxes. It should be noted that federal law prohibits states from taxing pensions, including IRAs and 401(k)s), payable to former residents (P.L. 104-95).
Moving expenses. While the cost of moving for a job or self-employment is tax deductible (Code Sec. 217), the cost of relocating in retirement is not deductible.
Retirement is a complex subject, which is further complicated by the tax implications of various decisions and actions. Taking a comprehensive tax approach to retirement can help to save taxes in the long run.
Executive Editor Sidney Kess is CPA-attorney, speaker and author of hundreds of tax books. The AICPA established the Sidney Kess Award for Excellence in Continuing Education in his honor, best-known for lecturing to over 700,000 practitioners on tax. Kess is senior consultant for Citrin Cooperman and is consulting editor to CCH.