Avoid These Tax Mistakes During Retirement

By Mark Cussen Markets Fool.com

Many retirees struggle to make ends meet after they stop working, and the rising cost of healthcare can make it even harder for them to stay afloat. The last thing they want to do is make mistakes that will cost them dearly come tax time. Retirees can keep more of their money out of Uncle Sam's hands by avoiding the following pitfalls.

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Not taking required minimum distributions

Traditional IRA and qualified plan owners are required to begin taking minimum withdrawals from these accounts on April 1 of the year after the year when they turn 70-1/2. Failure to do this will result in a whopping 50% penalty on the amount that should have been distributed, so make sure you take these distributions in a timely fashion and report them as income on your tax return.

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Timing a Roth conversion poorly

If you own a traditional IRA or qualified plan and would like to convert it to a Roth IRA, then you will pay income tax on the amount you convert. If you convert too much of your Roth IRA balance at once, you may end up knocking yourself into a higher tax bracket and incurring a bigger income-tax bill than you're ready to pay. You can avoid this by spreading the conversion out over the course of two or more tax years. Don't hesitate to consult a tax or financial advisor if you need help determining whether your conversion income will put you into a higher tax bracket.

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Not tracking your expenses

If you don't keep track of your spending, then you may be missing out on potential tax deductions. If you have substantial healthcare bills, then you may be able to deduct any expenses paid that exceed 10% of your adjusted gross income. If you're self-employed in any capacity, then be sure to record your business expenses so you can deduct them on your return. But be sure that your business is actually a business and not just a hobby; if your business runs in the red for three years or more, then the IRS will not allow you to continue deducting your expenses.

Failing to pay taxes

Don't think that the IRS won't eventually notice if you simply refuse to file or pay your taxes. Pay what you owe to Uncle Sam, and you'll steer clear of the penalties and interest that will be charged if you don't. The failure-to-pay penalty is 0.5% of the balance owed each month after the filing deadline up to a maximum of 25% of the balance owed, and the failure-to-file penalty is 5% of the balance owed every month after the filing deadline, up to the same maximum limit. (Note that the failure-to-pay penalty is subtracted from the failure-to-file penalty, so the actual amount of this penalty is 4.5% of the amount owed if you fail to file and to pay.)

If you're unable to pay the amount that you owe when you file, then you can set up a payment plan with the IRS or file for an offer in compromise. You can set up a payment plan by calling the IRS at (800)829-1040. If you want to do an offer in compromise, start by contacting the IRS Taxpayer Advocate Service here.

Filing your return with no help at all

If you aren't financially savvy, then don't hesitate to get professional help. A tax or financial advisor can help you to uncover deductions that you might not find on your own and show you tax-saving strategies that you may not be aware of. Filing your return without any kind of help may also increase the odds that you get audited, especially if your return is more complex and has lots of deductions and extra calculations. This could delay and possibly reduce or even eliminate your refund.

Those who still want to do it themselves should consider using some of the free or low-cost tax preparation software programs that are available online. According to the IRS, e-filed returns have an error rate of 0.5% versus a whopping 21% for returns filed on paper.

Taking early withdrawals from retirement accounts

The IRS will assess a 10% early-withdrawal penalty on any money that is taken from a traditional IRA before you reach age 59-1/2. There is a list of qualified exceptions to this rule (listed here and here), but if you don't qualify for one of them, then you'll be assessed the penalty. And it can be doubly expensive if you take early distributions from a Roth IRA. While you can withdraw your contributions to a Roth IRA at any time, anyearnings you withdraw prior to age 59-1/2 could be subject to the 10% penalty and income tax.

These are just some of the more common mistakes that retirees frequently make after they stop working. If you're not sure whether you're doing everything you can to reduce your tax bill, consult a tax or financial planner who can help you to ensure that you're getting all of the deductions and credits that you deserve.

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