Jamie explains why paying off your house as soon as possible is not the best plan. During our working years, the most significant deductions are usually mortgage credit and 401(k) contribution. One of the other big deductions during our working years is for charitable donations. During retirement, we usually start volunteering rather than donating, so we lose many of our large tax deductions in retirement.
After retirement, many average U.S. citizens may face a reduction in the number and size of tax deductions available to them, which can affect their overall tax liability. This change is due to shifts in income sources, spending patterns, and the tax code’s provisions for deductions.
Here’s a breakdown of how this loss of tax deductions occurs:
Reduction in Income-Related Deductions:
- No More Work-Related Deductions: Many people can deduct certain job-related expenses while working, such as unreimbursed employee expenses, union dues, and professional development costs. However, these deductions typically disappear after retirement since there is no longer an active employment income.
- Retirement Contributions: Contributions to retirement accounts, like 401(k)s or IRAs, often qualify for tax deductions during a person’s working years. Once retired, individuals stop making these contributions, eliminating those deductions from their tax returns.
Changes in Mortgage Interest Deduction:
- Paying Off the Mortgage: Many retirees have paid off their mortgages or have significantly reduced mortgage balances, which reduces or eliminates their mortgage interest deduction. Since the mortgage interest deduction is often one of the most significant deductions available, losing it can result in higher taxable income.
- Downsizing: Some retirees choose to downsize or move to smaller homes with lower mortgage payments, decreasing the mortgage interest deduction.
- State and Local Taxes (SALT) Deduction Limitations:
- Reduced Property Taxes: Retirees who downsize or move to areas with lower property taxes may have fewer state and local tax deductions. The SALT deduction is also capped at $10,000, which may limit the benefits even if property taxes remain significant.
Medical Expense Deduction:
- Higher Threshold: Medical expenses are deductible only if they exceed 7.5% of adjusted gross income (AGI). While retirees may have higher medical costs, their potentially lower income can reduce their ability to reach this threshold. Moreover, as retirees may rely on Medicare and supplemental insurance, some medical expenses might be covered, reducing out-of-pocket costs eligible for deduction.
Charitable Contributions:
- Reduced Cash Flow for Donations: Retirees often have fixed incomes, which can limit their ability to make large charitable donations. Consequently, the deduction for charitable contributions may decrease.
- Standard Deduction vs. Itemizing: The Tax Cuts and Jobs Act (TCJA) of 2017 nearly doubled the standard deduction, making it more likely that retirees will take it rather than itemize. If they do, they lose the benefit of deductions like charitable contributions, mortgage interest, and state and local taxes.
Impact of Required Minimum Distributions (RMDs):
- Taxable Income from RMDs: Retirees must begin taking required minimum distributions (RMDs) from traditional IRAs and 401(k)s starting at age 73. These RMDs are fully taxable as ordinary income, and because they increase taxable income, they may push retirees into higher tax brackets, reducing the benefit of remaining deductions.
After retirement, the average U.S. citizen may see a decline in available tax deductions due to changes in income, spending habits, and the structure of the tax code. This shift can lead to higher taxable income relative to deductions, potentially increasing overall tax liability despite a potentially lower overall income. Retirees need to plan carefully, possibly seeking tax-efficient strategies to minimize the impact of these changes on their finances.
