6 Big Tax Mistakes You Should Avoid With Your Retirement Money

You could end up paying unnecessary taxes when you leave your employer if you don't correctly fill out the paperwork to roll your company retirement account over to an IRA. No taxes come due when rollovers are done properly.

This is just one mistake you might possibly make with your retirement money. Numerous other rules can create headaches as well, but you can avoid high taxes in retirement in a number of ways.

Doing an IRA Rollover the Wrong Way

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Let's say you have $200,000 in a 401(k). You retire and take it as distribution, but you don’t fill out the paperwork correctly. Your company withholds $40,000 in taxes from your funds: 20% of the distribution amount.

You deposit the remaining $160,000 into an IRA within 60 days as a rollover, but now you have to come up with an additional $40,000 to deposit into this IRA in order for the entire $200,000 to count as a rollover.

What if you don’t have $40,000 available to put into the IRA to make up for the tax withholding that's already been sent to the IRS? That $40,000 is considered a taxable distribution from your account. You'll have to pay taxes on it, even if you meant for it all to be an IRA rollover.

That's $9,600 in taxes at a 24% tax rate that you could have avoided. You'll have to pay an extra 10% penalty tax, too, if you're under age 59½.

Not Understanding Required Minimum Distributions (RMDs)

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You're required to take distributions from your traditional IRAs or other formal retirement plans like 401(k)s or 403(b)s after you reach age 72. The ​amount you must withdraw is determined by a formula that's based on your age and your account balance as of Dec. 31 of the prior year.

Note

The age 72 rule applies only to plan participants who reach age 70½ in 2020 or later. Otherwise, it's age 70½ if you attained this age prior to 2020.

You're required to withdraw a higher percentage of the remaining balance each year as you get older. You can owe a penalty tax of up to 50% of the amount you were supposed to take if you fail to do so.

Required distributions can also apply to inherited IRAs and inherited Roth IRAs, even if you're younger than age 72 or 70½.

Not Withholding Tax on Pensions and Social Security

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Most forms of retirement income are taxable. Pension income is taxable, and your Social Security income may be subject to taxation as well. You must also report interest, dividends, and capital gains on any non-retirement accounts.

You could be in for a big surprise when you file your taxes in retirement if you don’t have the right amount withheld from your pension or Social Security income. You might consider speaking with a professional to do a tax projection to estimate your taxable income and your tax rate so you can be sure that you have the right amounts withheld.

Doing No Tax Planning Before Retirement

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Tax planning does you no good after the year is over. Low-income years can be particularly useful, and you can use them to your advantage. Losing a job or otherwise having less income for some reason is never good, but it might present a tax-planning opportunity.

You might be able to convert some of your IRA to a Roth IRA and pay little to no tax if you're experiencing a year where you have low income and high tax deductions, such as mortgage interest or health-related expenses. This can save you thousands of dollars, but it doesn’t happen unless you do your tax planning before the year ends.

Not Taking Advantage of IRAs

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Many people think that you can't fund IRAs if you have a retirement plan at work, but that's not necessarily the case. It depends on your income. You can still contribute to and claim a deduction for your contribution up if you're single and earn $76,000 or less in 2022.

This increases to $125,000 if you're married and filing jointly, although it plummets to $10,000 if you're married and file a separate return.

Note

Partial deductions are allowed over these income limits to some extent, and you might also be able to make a contribution on behalf of a non-working spouse.

Find out if your company retirement plan offers the ability to make Roth contributions. It's called a Designated Roth account through your 401(k) plan. Roth contributions are made with after-tax dollars, so they don’t reduce your current year’s taxable income, but your distributions come out tax-free when you withdraw the money.

Roth IRA withdrawals aren't included in the formula that determines how much of your Social Security income will be taxable, either. Learn the IRA rules and find out if you're eligible to make a traditional IRA, non-deductible IRA, or Roth IRA contribution each year.

Not Strategically Choosing How and When to Withdraw Income

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One of the biggest tax mistakes retirees make is taking Social Security early while waiting to withdraw from IRAs and other retirement accounts until they're required to do so.

Using your retirement money in the wrong order can mean paying thousands more in taxes each year than you would have had to pay if you'd rearranged things based on a strategy that would get you the most after-tax income.

This is especially true if you have no pension and most of your retirement income will come from Social Security and IRA money. An experienced retirement planner can help with this kind of planning, and it can result in more after-tax retirement income for you.

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Sources
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  1. Internal Revenue Service. "Rollovers of Retirement Plan and IRA Distributions."

  2. Internal Revenue Service. "IRS Provides Tax Inflation Adjustments For Tax Year 2022."

  3. Internal Revenue Service. "Retirement Topics - Exceptions to Tax on Early Distributions."

  4. Internal Revenue Service. "Retirement Plan and IRA Required Minimum Distributions FAQs."

  5. Internal Revenue Service. "IRA FAQs—Distributions (Withdrawals)."

  6. Internal Revenue Service. "Retirement Topics—Required Minimum Distributions (RMDs)."

  7. Internal Revenue Service. "Topic No. 410 Pensions and Annuities."

  8. Internal Revenue Service. "Topic No. 423 Social Security and Equivalent Railroad Retirement Benefits."

  9. Internal Revenue Service. "Publication 525 (2020), Taxable and Nontaxable Income."

  10. Internal Revenue Service. "IRS Announces 401(k) Limit Increases to $20,500."

  11. Internal Revenue Service. "Roth IRAs."

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