Even though the April 18 income tax deadline has passed, it’s worth exploring how to plan to pay for some common expenses in retirement to receive the most tax benefits, ahead of the next filing deadline in April.
One of the most foundational tax-planning questions a retiree faces is how to best pay for expenses while minimizing the tax impact. Fortunately, the Internal Revenue Service allows several tax-advantaged ways to accomplish this goal, depending on the funding source and type of expense.
Here are five common expenses in retirement that could cut your tax bill:
Fund a Grandchild’s Education from a 529 Plan
Anyone can contribute to a 529 plan to help pay for a child or grandchild’s education. This money has several advantages: tax-free growth, tax-free withdrawals if used for qualified education expenses, and no estate taxes due. Contributions count toward the annual $16,000 per person annual gift tax exclusion limit; however, a unique tax rule for 529 plans allows donors to effectively front-load up to five years’ worth of contributions and avoid gift taxes.
About 30 states offer a state income tax deduction for 529 plan contributions. For example, Georgia provides a deduction on contributions up to $8,000 per beneficiary to the state’s Path2College 529 plan.
While people in states without state income tax incentives don’t receive a tax deduction, there may be other long-term benefits. For example, someone may want to move assets out of their taxable estate, have a concern for higher income tax rates in the future, or simply like the idea of having assets for education earmarked in a separate, designated account for a grandchild or family member.
Pay for Medical Expenses from a Health Savings Account
HSA contributions are tax-deductible, the funds grow tax-free, and distributions are tax-free if used for qualified medical expenses. Many retirees during their working years contributed to Health Savings Accounts and used their earned income to pay for healthcare costs to allow the HSA funds to grow.
While people can’t fund an HSA once they begin receiving Medicare, they can use an HSA to pay for out-of-pocket medical expenses such as doctor’s bills and prescriptions. The funds can even be used to pay for Medicare Parts B and D premiums.
Since HSA distributions for qualified medical expenses are tax-free, retirees with this type of account can reduce their need to take withdrawals to pay for medical costs using other taxed sources, such as IRAs and 401(k)s. The tax impact over time in retirement could translate into thousands of dollars saved, especially for retirees who aren’t able to offset taxable withdrawals by itemizing their medical costs.
Pay for Long-Term Care Insurance Premiums from an Annuity
The IRS allows a strategy, called a partial 1035 exchange, to pay for long-term care premiums from a non-qualified annuity without creating a taxable event. Since the growth in a non-qualified annuity will eventually be taxed as ordinary income, taking a portion each year out of the annuity to pay the long-term care insurance premium can help reduce a retiree’s eventual tax burden.
There are a few technical considerations to make sure this works for your situation. These include the impact of otherwise deducting the LTC premium payments on your taxes, the financial need for the annuity payments, and checking with your annuity company to ensure that they can facilitate this transaction. It’s also important to note that this exchange will create a pro-rata reduction in your annuity cost basis.
This strategy can be an effective way to minimize taxes for people who don’t need to tap their annuity yet, and who would otherwise need to take a taxable distribution from a retirement account to pay the premiums.
Make Charitable Donations from an IRA
Many retirees who contribute to their favorite non-profit organizations don’t receive a tax benefit since their standard deduction exceeds any itemized deductions. Account owners age 70.5 and older could benefit by using their IRA as the source of their giving, a strategy called a Qualified Charitable Distribution (QCD).
While you do not receive a tax deduction for a QCD, the distribution is not taxed. Lower top-level income could lead to other benefits, such as lowering Medicare premium surcharges. Keep in mind that the distribution must be taken directly from your IRA for the amount to be excluded from income. Account owners can donate up to $100,000 per year from their IRA, and the QCD amount goes toward your annual required minimum distribution.
Make Family Gifts from Investments or Business Interests
Many retirees who give money to a child or grandchild just write a check. However, if a large portion of their wealth is in a tax-deferred account, a taxable investment portfolio or a business, they may want to consider making this gift from a portion of an appreciated asset or business interest.
Here’s a simple example. If you have held Apple stock for years, instead of writing a check for $10,000 as a Christmas gift, give a grandchild the gift of $10,000 of your stock. While the grandchild will eventually owe taxes on any sale, they can learn about investing by watching the price (hopefully) appreciate, and the capital gains taxes may be comparably lower for them. The retiree saves money on the capital gains tax and also reduces the size of the estate.
While a tax law provision called "step-up in basis" — which adjusts the value of the assets someone inherits at the owner's death — could leave heirs with a smaller income tax bill if they later sell the positions, there are good reasons for gift-givers to use appreciated stock or mutual funds instead of cash. They may want to lower the size of their taxable estate, reduce a large position in one or more stocks, or let a young family member gain firsthand experience investing in the stock market.
These five expenses don’t cover every situation for every retiree but considering these recommendations could end up saving a few hundred or a few thousand dollars annually.
Chase Mouchet, CFP®, CIMA® is a partner and wealth adviser at CI Brightworth, focusing on helping clients prepare for life in retirement through the firm’s Retiring Well practice area. He is passionate about helping clients simplify their financial lives and maximize the impact of their wealth, particularly through charitable giving. He received his BBA in Finance and BSFCS in Financial Planning from the University of Georgia.