The taxman still cometh
Just because you're retired doesn't mean the IRS has gone away
Taxpayers may retire, but the tax collector never rests. Nevertheless, the tax code by and large favors the elderly. "Lower income may qualify you for new or bigger tax breaks, and there may be deductible expenses, such as for medical care, that you didn't have before," notes Bernard Kent, a personal financial services partner at PricewaterhouseCoopers, the giant tax and auditing firm.
Some seniors may even find they owe no income tax at all, thanks to various special exemptions and deductions. Others may find they can now use the simpler 1040A form if, for example, they had been claiming itemized deductions but now opt for the standard deduction, which is higher for those 65 or older. For 2004 returns, the fixed standard deduction is $6,050 for a single senior, $11,600 for a married couple in which both spouses are 65 or older, and $10,650 for a couple in which only one spouse is 65 or older. But few things in the tax laws are straightforward. Here are some twists to keep in mind.
What happened to withholding? Your employer may have handled most of your tax payments. Retirees must adjust to not having tax withheld on income from investments, bank accounts, pensions, and Social Security. The danger is both a big bill when you file your return and a possible underpayment penalty.
You can ask that tax be withheld from Social Security if you expect your benefits to be taxed. In other cases, such as pensions and annuities, tax is usually withheld unless you elect otherwise. Quarterly estimated tax payments, using Form 1040ES, can take the place of withholding. If you are 62 or older and a new retiree, the IRS may waive a penalty if you claim extenuating circumstances. That's done on Form 2210.
Social Security's bite. It may seem like the unkindest cut to retirees who have put after-tax cash into Social Security all their working lives, but Uncle Sam may also take a bite out of the benefits they now receive. Depending on income, as much as 85 percent of Social Security benefits may be subject to possible income tax. In general, you'll be among the 1 in 3 beneficiaries hit if your adjusted gross income (AGI), plus tax-exempt interest from, say, municipal bonds, plus half your Social Security benefits add up to more than $25,000 for a single person and $32,000 for a couple. Working part time? Sorry, you'll also have to pay normal Social Security tax on those earnings. And, if you retired before 65, you'll lose $1 in benefits for each $2 earned above a limit of $11,640 in 2004.
Paying the doctor. It may be cold comfort, but seniors with newly modest incomes and sizable unreimbursed bills may find it easier to get over the tax code hurdle that limits medical expense deductions to the amount by which they exceed 7.5 percent of AGI. Items such as tooth implants and bridges, hearing aids, glasses, nursing expenses, and premiums for Medicare and other health insurance can add up. Modifying a home could possibly qualify as a deductible expense--a stairway chairlift for someone with a heart condition, perhaps. Even a pool might partially qualify as physical therapy, but you may have to argue with the IRS if you get audited. Note: Depending on your income, only some or none of Social Security benefits have to be included in AGI when calculating the 7.5 percent threshold.
When credit is due. Retirees 65 or older with limited income and meager or no Social Security benefits may qualify for part of a tax credit of up to $750 for individuals and $1,125 for couples. But it's a limited break: The credit is reduced as income rises and is phased out completely when, for example, a single person's AGI hits $17,500. A couple in which both spouses are 65 or older is ineligible when AGI hits $25,000. Also, the credit phases out if you receive Social Security benefits and is erased, for example, when benefits exceed $5,000 for a single person or $7,500 for a 65-or-older couple.
Taking care of the kids. Grandparents bringing up young children may be able to claim a dependent deduction--$3,100 for each qualifying child in 2004--as well as the current $1,000-per-child tax credit for children under age 17. But the person claiming the deduction or credit must generally supply over half the child's support, and if your income exceeds certain levels, part or all of the deduction and credit may be barred. Note: Well-to-do grandparents can get a break on estate tax by helping grandchildren with schooling. Tuition payments are not subject to gift tax if they're paid directly to the educational institution, and this reduces the assets left in an estate to be taxed.
Tapping a nest egg. You can't take your retirement benefits with you, but neither can you haphazardly pass them on to heirs. Tax-deductible deposits in traditional IRA s, for example, must start to be withdrawn after age 70 1/2 in minimum yearly amounts based on an IRS formula tied to life expectancy. A separate formula can lower the minimum amount if your spousal beneficiary is more than 10 years younger than you. Funds in a Roth IRA can be left untouched with no required minimum withdrawals. (In these accounts, there's no deduction for deposits, but withdrawals typically are not taxed or only partly so.) Rules for other plans vary--those who are still employed can often delay taking money from a 401(k) beyond age 70 1/2, an option not available for IRA balances.
Though you may have a choice, an employer may make a lump-sum distribution of your 401(k) assets when you leave a firm. You can avoid tax by rolling over the money into an IRA or other retirement plan--with limits for people over 70 1/2. People born before 1936 may benefit from a special break known as 10-year averaging on 401(k) and some other retirement plan distributions. Tip: If you have several IRAs, the required total minimum distribution for all of them can, if you wish, be satisfied with an equivalent withdrawal from just one of them. That can allow you to choose which to keep.
Pulling up stakes. Many retirees move into smaller housing or to a new location. That opens up a major tax saver for people who pull in a profit from the sale of their home. Up to $250,000 of profit--$500,000 for a couple--can escape tax. You can claim the break again for later moves, and it is available to people of all ages. One test: You must generally have lived in the home as your principal residence for at least two of the past five years before the sale.
Note: Although the IRS checks post office change-of-address records, directly notifying the agency can safeguard against misdirection of IRS mail. Last year, some 93,000 refunds worth an average of about $722 were returned to the IRS because of invalid addresses. Use IRS Form 8822.
This story appears in the June 14, 2004 print edition of U.S. News & World Report.