How to Minimize Taxes During Retirement
If you regularly pour money into your IRA or 401(k) accounts, you might be rewarded with a handsome balance by the time you retire.
The tax-deferred nature of these types of accounts helps to grow balances faster.
You don’t have to worry about paying taxes on your earnings and capital gains as you go.
However, when you start pulling money out of these accounts, it’s time to pay the piper.
Find out how you can minimize your tax burden in retirement.
For most traditional IRA and 401(k) accounts, withdrawals are fully taxable.
If you’re earning taxable investment income as well, your tax problems only multiply.
You can’t avoid paying taxes on taxable income, but there are ways to cut the taxes you have to pay.
Some of these strategies require advance planning.
If you’re still a younger saver, you can take note of these suggestions now.
Others are for those approaching retirement age.
So, some of these tips help make the most of your retirement plan withdrawal strategy.
In either case, you can take concrete steps to reduce your retirement tax bill.
1. Know Your Income and Tax Bracket
Tax brackets can change from year to year, so it pays to keep on top of current tax law.
Taxable retirement distributions are added to your taxable income for the year. They are in the same income class as the money you earn from your job.
If you take out too large of a distribution, you might get kicked up into the next tax bracket.
This amounts to leaving money on the table, and for no good reason.
Here’s an example:
Let’s say you are single and have $80,000 in taxable income from your job.
For the tax year 2020, that puts you near the middle with a 22 percent tax bracket, which cuts off at $85,525.
Now, if you take a $10,000 taxable retirement plan distribution, your income will jump into the 24 percent tax bracket.
The first $5,525 of your retirement plan distribution will be taxed at 22 percent.
However, the remaining $4,475 will be taxed at 24 percent, not 22 percent.
This amounts to an additional $400 in taxes.
If you can instead put off that distribution until the following year, you can remain in the 22 percent tax bracket.
2. If You’re Older, Consider a Lump Sum Distribution
Withdrawals from a qualified retirement plan are generally fully taxable as ordinary income.
An employer-sponsored pension plan is an example of a “qualified” retirement plan.
However, the IRS allows special tax treatment of lump sum distributions for those born before January 2, 1936.
A lump sum distribution is the payout of the entire balance of an employer’s qualified retirement plan within a single tax year.
Lump sum distributions must meet the following additional requirements as well:
- Made after age 59.5, or
- Made due to the death of an account holder, or
- If an employee separates from service, or
- If a self-employed individual becomes totally and permanently disabled
If those requirements are met, the IRS allows account holders to select one of five options for the treatment of the lump sum.
The specifics are a bit complicated, but four of the five options provide a tax benefit.
The five options are:
- Report the taxable portion of the distribution from activity before 1974 as a capital gain, and the remainder as ordinary income
- Report the taxable portion of the distribution from activity before 1974 as a capital gain, and use the “10-year tax option” for the remainder
- Use the “10-year tax option” for the entire balance
- Rollover the distribution into another tax-advantaged account
- Report the entire withdrawal as taxable income
Capital gains are taxed at a lower rate than ordinary income, so reporting a portion of the distribution as a capital gain can reduce taxes.
Similarly, the 10-year tax option can reduce taxes over option five, in which recipients pay ordinary income tax on the entire amount.
The bottom line is:
If you were born before January 2, 1936, you have some options for reducing the tax on your qualified plan distribution.
3. Withdraw After-Tax Contributions First
Most contributions to retirement plans like 401ks and traditional IRAs are made on a pre-tax basis.
You don’t have to pay tax on the money you contribute.
However, some retirement plans, including some 401k plans and traditional IRAs, allow for after-tax contributions.
With an after-tax contribution, you don’t get a tax deduction on your contributions.
However, you are able to withdraw them from your retirement plans tax-free.
This can help knock down your tax bill in retirement, as you can withdraw those contributions first, before any of your distributions are taxable income.
4. Withdraw Roth Contributions and Earnings First
Similar to a pre-tax contribution to an IRA or 401k, contributions to Roth IRAs are typically made on an after-tax basis.
Here's the kicker:
Not only can you withdraw your Roth contributions on a tax-free basis, you can also withdraw any earnings from your Roth IRA tax-free.
There are some caveats.
For example, to qualify as a tax-free distribution, your Roth withdrawals must be made after age 59.5, and you must have had the money in a Roth account for at least five years.
However, after that, you can pull any amount out of your Roth on a tax-free basis.
5. Move to a Low-Tax State
When some people retire, they consider moving to a different state.
For some, it is wanderlust.
For others, it could mark a return to the state of their origin, having been dragged somewhere else for work.
Whatever the reason, if you’re considering looking for a new place to live when you retire, don’t overlook tax considerations.
As of 2018, seven U.S. states levy no income tax.
Those states are:
- South Dakota
If you’re coming from a high-tax state, such as California, you might save 10 percent or more in taxes on your investment income.
This could make a big difference in your bottom line when it comes to taxes in retirement.
Let’s say you earn $25,000 per year in taxable income from dividends, interest or taxable retirement plan distributions.
The middle-income tax bracket for a married taxpayer in California is 9.3 percent.
On an income of $25,000, that amounts to $2,325 in tax savings every year if you move from California to a tax-free state.
If your retirement lasts 30 years, you could save almost $70,000 in state income tax by moving to a low-tax state over the length of your retirement.
6. Invest in Qualified Dividends
Dividends are cash or stock payouts from companies to shareholders. They typically reflect a portion of the company’s profits.
Traditionally, dividends have been taxable as ordinary income.
As of 2018, this means that taxpayers in the top bracket would owe 37 percent tax on those dividends. This is in addition to any state or local taxes, as well.
However, many dividends can qualify for special tax treatment.
If you hold a dividend-paying security, like a stock, for a certain amount of time, that dividend becomes “qualified.”
According to the IRS:
Most dividends are qualified if you hold them for at least 60 days during the 121-day period before a stock goes “ex-dividend,” or trades without the dividend. This usually happens quarterly.
Qualified dividends are treated as capital gains for tax purposes.
This means the tax rate on those dividends, for 2018, is either 0 percent, 15 percent or 20 percent, depending on your overall tax bracket.
This can result in big savings if you’re holding these dividend-payers throughout your retirement.
7. Maximize Long-Term Capital Gains
You can take advantage of the same reduced capital gains tax rates that you do for qualified dividends by buying and selling capital assets.
Stocks are probably the most common example of an easily traded capital asset.
For example, if you buy 100 shares of IBM at $150 per share and sell those shares at $200, you have a $50-per-share capital gain, or $5,000.
However, short-term capital gains, or those held for one year or less, are taxed as ordinary income.
To benefit from the capital gains tax rates, you need to generate long-term capital gains.
A long-term capital gain is one that you have held for longer than one year.
In the IBM example, you would have to hold that stock for longer than one year to make that $5,000 gain long-term.
Then, your tax rate on that gain would be either 0 percent, 15 percent or 20 percent.
If you’re retired, try to hold off selling your short-term investments until more than one year has passed. Depending on your tax bracket, the savings could be significant.
You should never make investment decisions solely based on tax reasons.
However, it can help your overall financial picture if you understand how investment taxes work.
Take advantage of the tax benefits offered by retirement accounts, particularly when it comes to tax-deferred earnings and tax-free withdrawals, where applicable.
Structure your investment portfolio so that it’s as tax-friendly as possible, while still meeting your investment needs.
And wherever possible, prioritize long-term capital gains over short-term ones when it comes time to sell some stocks or other capital assets.
If you incorporate even one of these tips into your financial strategy, you can help minimize your taxes in retirement and keep more of what you earn.