You worked hard to save enough money for retirement, but that’s only part of the battle. Once you retire and rely on that money as your main income source, the last thing you want is for the government to get a big chunk of it. Most people will enter retirement with less money than they need, so you’re wise to minimize taxes. In fact, even if you have saved a lot of money, you’ll still want to pay the lowest amount of taxes possible.
1. Know What’s Taxable
That’s easy—just about everything is taxable. The question is, when is it taxable? If you have investments outside of tax-advantaged retirement accounts, they’re taxable each year, whether you are retired or not. These may include brokerage accounts, real estate, savings accounts, and others.
Most retirement-designated income, on the other hand, is not taxable until you actually retire. Then, it is. Withdrawals from traditional IRAs, 401(k)s and 403(b)s—and payments from annuities, pensions, military retirement accounts, and many others—may be taxable.
The Roth IRA, on the other hand, is a hybrid. The money you put into a Roth account is taxable before you make the deposit, but the investment gains are tax-free if you wait to withdraw them until you experience a “qualifying event.” Turning 59½ is one qualifying event; some research on your own or with the help of a financial advisor will help you figure out the others, as well as which other assets are taxable, tax-deferred, or exempt.
2. Know Your Tax Bracket
According to Nathan Garcia, CFP, wealth advisor at Strategic Wealth Partners in Maryland, “The easiest way to reduce taxes is by keeping your income within the tax bracket that taxes long-term capital gains at 0%. Doing so will also keep your ordinary income taxes in the 15% bracket.”
For the tax year 2020, the top tax rate remains 37% for individual single taxpayers with incomes greater than $518,400 ($622,050 for married couples filing jointly). The other rates are:
- 35%, for incomes over $207,350 ($414,700 for married couples filing jointly)
- 32% for incomes over $163,300 ($326,600 for married couples filing jointly)
- 24% for incomes over $85,525 ($171,050 for married couples filing jointly)
- 22% for incomes over $40,125 ($80,250 for married couples filing jointly)
- 12% for incomes over $9,875 ($19,750 for married couples filing jointly)
The lowest rate is 10% for incomes of single individuals with incomes of $9,875 or less ($19,750 for married couples filing jointly).
Meeting the income requirements is not always easy. “A lot of planning has to go into properly executing this strategy because you must incorporate Social Security, pensions and other income sources along with any retirement account distributions,” said Garcia. “You or your advisor has to have a clear understanding of your basis in your non-qualified investment accounts.”
3. Convert to a Roth
Remember, a Roth IRA taxes you now instead of when you withdraw the money. Paying taxes now, while you’re still working, eliminates the tax burden later in life when you need all the money you can get.
Josh Trubow, CFP, of Sensible Financial Planning said, “Without assuming any changes to the tax code in the future, doing Roth conversions in low-income years is a strategy for paying taxes at a lower tax bracket by shifting when you realize the income. We determine how much the client should convert on a year-by-year basis in order to fill up the lower tax brackets and pay taxes at a lower rate (now) than they would if they waited and withdrew funds in a year when they’ll be in a higher tax bracket.”
4. Tax Diversification
Just as you should diversify your investment portfolio to avoid large-scale losses, you should do the same with your taxes because your tax bracket likely will fluctuate at various times in your life.
Chris Kowalik of ProFeds, federal retirement expert and frequent speaker to federal employees on financial planning, said “Tax diversification is the concept that during various economic times, a retiree has several buckets of money to choose from. When taxes are relatively high, a retiree might choose to take income from a tax-free account. When taxes are relatively low, a retiree may choose to take income from a taxable account.”
5. Consider Moving
Ever wonder why Florida is such a popular destination for retirees? It’s not just the beaches—it’s the lack of state income tax. Along with Florida, Alaska, Nevada, South Dakota, Texas, Washington, and Wyoming all lack state income tax. However, that does not necessarily mean that the living is easier there or in other popular retirement states in the U.S.
Anthony D. Criscuolo, CFP, Palisades Hudson Financial Group, says, “This strategy [of moving] can work, but it isn’t the only solution. One option is to invest in state-specific municipal bond funds. But before you do anything, understand how state and local taxes will affect your retirement nest egg.”
The key to keeping your retirement taxes low is not to wait until retirement to start planning. Instead, make plans well before you need to rely on your retirement savings as your main source of income. Financial planning is no easy task. It’s best to seek the advice of a financial advisor with experience in designing tax-efficient wealth-management plans.