Many seniors struggle financially when they go from earning a salary to living off a more limited fixed income. That's why it's important for retirees to take advantage of whatever tax breaks come their way. Here are three in particular you should know about.
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1. Roth IRA distributions
When you save for retirement with a traditional IRA, the withdrawals you take as a senior are subject to ordinary income taxes, which means you'll automatically lose a portion of each distribution to the IRS. Roth IRA distributions, however, are taken tax-free, which means once you start removing money from your account in retirement, you get to pocket those withdrawals in full.
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While Roth IRAs don't offer the same up-front tax benefits as traditional IRAs, opening a Roth can help minimize some of the tax-related risks many seniors face in retirement. For example, traditional IRAs impose required minimum distributions (RMDs) once you turn 70-1/2, which come with their own tax consequences. Roth IRAs don't impose RMDs, thereby removing this concern. Furthermore, while you know what your tax rate looks like today, we can't know how tax brackets will shake out in the future. Eliminating taxes on withdrawals can help you protect yourself from unfavorable changes over time.
2. Medical expense deductions
Healthcare is a huge burden for many retirees. The good news is that if you spend a large enough chunk of your income on healthcare costs, you'll be eligible for a tax break. The medical expense deduction allows taxpayers to deduct healthcare expenses that exceed 10% of their adjusted gross income (AGI). So if your AGI for the year is $50,000 and you spend $6,000 on medical expenses, you'd be eligible to deduct $1,000 on your taxes. As long as you retain detailed records, you can include things like in-office and drug copays, Medicare premiums, and travel to and from appointments (including parking fees).
3. Credit for the elderly or disabled
The credit for the elderly or disabled offers a much-needed dose of tax relief to low-income seniors and disabled Americans. Though most seniors don't qualify because of the income limits involved, if you are eligible for the credit, it could reduce your taxes significantly.
Here's a quick refresher on how tax credits works. Unlike deductions, which reduce the amount of your income subject to taxes, a tax credit is a dollar for dollar reduction of your tax liability. If your effective tax rate is 25% and you score a $1,000 tax deduction, you'll get a tax savings of $250. But with a tax credit, you'll directly shave $1,000 off your tax bill.
In order to qualify for the tax credit for the elderly or disabled, you must be 65 or older by the end of the tax year you're claiming the credit for, or retired on permanent and total disability with taxable disability income. Here's what the current income limits look like for this credit:
DATA SOURCE: IRS.
As you can see, qualifying for this credit gets tricky, especially since you won't be eligible if your income exceeds the limit in either of the above categories. But if you are eligible, you could reduce your taxes by up to $7,500.
One final thing to keep in mind about the credit for the elderly or disabled is that it isn't refundable. This means that if it knocks your taxes down below $0, you won't get a check for the difference. That said, wiping out your tax liability can still work wonders for your finances, so if you're a lower earner, it pays to run the numbers and see if you're eligible.
Many seniors are caught off-guard by the taxes they need to pay in retirement. The more tax breaks you're able to capitalize on, the more income you'll get to retain at a time in your life when you need that money the most.
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