Pensions, Homes Could Lessen Tax Bills for Retirees
Finding ways to save on income taxes when you’re on a fixed budget is a challenge. Nevertheless, there are a few things that retirees can do to lower their tax bills in coming years, such as deferring pension payouts where appropriate and keeping a close eye on deductible medical expenses.
Paying off a home mortgage might also be a key to tax savings for those who have Social Security income and money in the bank, said Phil Holthouse, partner at the accounting firm of Parks Palmer Turner & Yemenidjian in Los Angeles.
Consider John and Jane Smith, our hypothetical retired couple. They earn $50,000 annually--$15,000 from Social Security, $27,000 from pension benefits and $8,000 in interest and dividends on a $100,000 investment portfolio. Meanwhile, they have $5,000 in uninsured medical expenses and pay 9.5% interest on a $100,000 home mortgage.
In 1990, their adjusted gross income will be only $40,250 because part of their Social Security benefits are excluded from tax. (The percentage excluded depends on total income.)
They are able to deduct $1,981 of their total $5,000 in out-of-pocket medical expenses since these expenses are only deductible to the degree that they exceed 7.5% of adjusted gross income. However, all of their home mortgage interest payments of $9,500 will be used to reduce their taxable income, as will the $3,500 they pay in state income and property taxes. Total itemized deductions: $14,981.
After subtracting their itemized deductions and personal exemptions of $4,100 from adjusted gross income, the Smiths’ taxable income drops to $21,169 ($40,250 minus $19,081). That puts them in the 15% bracket, so they’ll pay $3,176 in federal taxes.
Yet, if they sold their investment portfolio and used that money to pay off their home mortgage, they would reduce their federal tax liability by $562 and have more disposable income as well.
It may seem inconceivable that you could reduce your tax by eliminating your primary itemized deduction, but because of special rules relating to older taxpayers, it can save some people a significant sum. This is primarily because the government taxes Social Security benefits once an individual’s income exceeds a certain level.
When the Smiths declared $8,000 in interest and dividend income, $5,250 of their Social Security benefits were taxable. Without the $8,000 in investment income, only $1,250 of their Social Security benefits are taxable. They are also, of course, not paying tax on that $8,000.
Meanwhile, they will no longer itemize deductions because, without the mortgage interest, total itemized deductions are less than the standard deduction of $6,750.
In the end, their taxable income drops to $17,400 and their tax amounts to $2,614. Since they were paying $9,500 on their $100,000 mortgage and earning only $8,000 on their $100,000 investment portfolio, they will also now find themselves with $1,500 more in disposable income during the year. Total savings: $2,064.
Nevertheless, Holthouse notes that some retirees may decide not to use this strategy simply because they are uncomfortable with the idea of draining their savings accounts and leaving themselves with no financial cushion.
This is a valid concern. If unforeseen expenses crop up, this couple could borrow against the equity in their house, but it would cost them. Typically, upfront fees on a home equity loan would amount to 1% to 2% of the total loan amount. If they were forced to borrow within a year or two, they would eliminate all of the financial benefit of following this tax strategy.
Assuming the Smiths do not want to pay off their house, they should be careful to keep track of all their itemized deductions, particularly their medical expenses, said Gregg Ritchie, partner at the accounting firm of KPMG Peat Marwick.
Older Americans often find that they are spending a significant percentage of their income for prescriptions, doctor visits and, sometimes, full-time nursing care. At the same time, their income is usually smaller than it was when they were working, so they will be able to deduct a bigger portion of these expenses.
They might also consider delaying some pension payments in order to lower their taxable income and decrease the taxable portion of their Social Security benefits.
However, retirees with significant assets will find that they could probably save much more through proper estate planning than they ever could through income tax strategies. Unfortunately, though, these savings will be enjoyed by their heirs rather than the taxpayers themselves.
The reason the savings are higher is because estate tax rates are higher. The top estate tax rate is 55%, compared to today’s top income tax rate, which in most cases is 28%.
However, the government allows each individual to give up to $600,000 to their heirs tax-free. So, John and Jane Smith could leave their children up to $1.2 million before any additional tax would need to be paid.
Many couples lose the benefit of one spouse’s $600,000 exclusion, though, because they leave all their assets to the surviving spouse. Instead, Holthouse said, the couple should consider writing a will that would bequeath $600,000 to a trust that will eventually go to the couple’s heirs.
To ensure that the surviving spouse is still well provided for, they can stipulate that all the income from that $600,000 inheritance must go to the survivor and only revert to the heirs after the second spouse’s death.
If the couple’s estate was worth $1.2 million--not unlikely in California, where a relatively simple residence might be worth $500,000--this one move could save $235,000 in taxes, Holthouse said.
RETIRED COUPLE John and Jane Smith, our hypothetical retired couple, earn $50,000 annually--$15,000 from Social Security, $27,000 from a pension and $8,000 in investment income. They have a $100,000 mortgage at 9.5% and paid $5,000 in uninsured medical expenses in 1990. Here’s what they’d pay in 1990, and what they might pay in 1991, assuming that they take advantage of some new tax planning options and that tax rates remained unchanged.
1990 1991 Wages 0 0 Interest/dividend income $8,000 0 Social Security (taxable part) 5,250 1,250 Pension income 27,000 27,000 Mortgage interest deduction 9,500 0 Deduction for state & local taxes 3,500 0 Medical expenses (deductible part) 1,981 2,881 Total itemized deductions 14,981 0 Standard deduction 0 6,750 Personal exemptions 4,100 4,100 Taxable income 21,169 17,400 Tax 3,176 2,614
Source: Ben Shiao, Parks Palmer Turner & Yemenidjian, Los Angeles.
