Key Takeaways:
- A coordinated retirement income strategy can help reduce taxes by carefully timing withdrawals from IRAs, 401(k)s, Roth accounts, taxable investments, pensions, and Social Security.
- Roth conversions and planned withdrawals during lower-income years may create tax-saving opportunities while potentially reducing future required minimum distributions and taxable income.
- Ongoing tax planning matters throughout retirement, as withdrawal decisions can affect Social Security taxation, Medicare premiums, capital gains, charitable giving, and how much income you ultimately get to keep.
Retirement income withdrawals, such as from an IRA, pension, 401(k), as well as Social Security benefits, are all added together to determine how much you will owe in taxes and therefore how much you get to keep after the government takes its share.
What matters is how much you get to keep after paying Uncle Sam.
How can you reduce taxes owed on retirement income? Coordination! How, when, and to what degree you use these benefits will determine how much you will owe in taxes. Therefore, having a coordinated plan among these sources of funding can be critical to keeping the tax burden to a minimum.
Understand How Each Retirement Income Source Is Taxed
The first step in understanding how to reduce the taxes owed on your retirement income is to know how the IRS treats each type of retirement account. Do this BEFORE making withdrawals from your accounts.
Different retirement account types are treated differently by the IRS. You do NOT want to paint the different retirement accounts with the same brush.
What matters most with retirement accounts is after-tax income amounts. Taxes can take out a substantial amount of your retirement income before you get to spend it. Calculate the after-tax retirement money, not the before-tax amount.
Tax-Deferred Accounts
Common retirement plans such as IRAs, 401(k)s,403(b)s, and other such accounts will be taxable to you when you withdraw money from them. These types of accounts will be taxed when funds are withdrawn as ordinary income.
The larger the balance within such accounts, the larger the distributions will be when you must start taking withdrawals.
Because large retirement accounts require large withdrawals, the greater the need for a coordinated plan to keep your tax situation to a minimum. Plan before taking the withdrawals, not after. Planning could save you thousands of dollars that would have gone to taxes.
Roth Accounts and Cash Reserves
Roth accounts, when used properly, can provide tax-free income. Certain requirements must be met, such as reaching a certain age or having the account established for a minimum number of years.
Taking withdrawals from Roth IRAs can be tax-savvy when you need money and are in a high tax bracket.
When there is a need for cash in a short-term situation, having cash reserves can provide funds without tapping retirement or taxable investment accounts.
Taxable Investments, Pensions, and Social Security
Dividends, capital gains, mutual fund distributions, pension withdrawals, and annuity withdrawals can all increase your taxable income. Depending upon your tax bracket, it is prudent to review such withdrawals/distributions before making them.
Social Security payments may become taxable depending upon the income tax bracket you fall into. Distributions from your investments can be counted as income, which would push you into a higher income tax bracket and make part of your Social Security payment taxable.
This is why it is so important to review your situation with a qualified accountant to determine how best to take distributions from your various investment accounts while keeping your tax bracket as low as possible, thereby avoiding unnecessary income taxes.
Choose Withdrawal Sources to Manage the Tax Bill
Employing a qualified accountant should help you decide how best to take withdrawals from the different investment accounts that you have. The goal is to keep your income as low as possible while still withdrawing the amount you need.
The order you withdraw from your accounts can affect: taxes, Medicare premiums, Social Security taxation, future retirement plan distributions, portfolio longevity, and your ability to choose which account is best to take from in the future.
Which accounts you take from (IRAs, taxable accounts, Roth IRAs, cash) will depend upon your tax situation and tax bracket at that time. This is why continually monitoring your situation is critical.
As discussed earlier, being tax-wise means continuously reviewing your withdrawal situation. Factors to consider: income, tax bracket, account balances, age, and any upcoming mandatory withdrawals from retirement accounts.
Use Lower-Income Years Before Required Withdrawals Begin
The period of time between your retirement from work and before having to take withdrawals from your retirement plans, Social Security, or any other income can provide tax-planning opportunities that will, in the end, lower your taxable income. Review the possibility of converting part of your traditional IRA to a Roth IRA to reduce future mandatory distributions from the IRA.
By strategically taking withdrawals to fall into a lower tax bracket, you can reduce your overall tax bill. This requires year-by-year evaluation of your tax situation.
Roth Conversions
A Roth conversion allows you to move money from your traditional IRA to a Roth IRA. However, when you do this, the amount moved from the IRA to the Roth IRA will be considered a distribution and therefore taxable to you as if it were income.
A Roth conversion has the advantage of reducing your future required distributions, which decreases your taxable income.
Before converting a traditional IRA to a Roth IRA, you must consider the following: your current tax bracket vs. future expected tax brackets, how the additional income created by the conversion affects your Medicare premiums, and where you will get the money to pay for the tax that will come due when the conversion takes place.
Planned IRA Withdrawals
Sometimes it makes economic and tax sense to take IRA withdrawals before they are required. Why? By doing so, you avoid having to take a larger distribution later and being caught in a higher tax bracket. It might make sense to “level off” your IRA distributions over a longer period of time by not waiting until you must start taking them.
Try to coordinate your withdrawal from your retirement plan(s) with your spending needs, tax projections, and the balance of your other investments.
Watch Income Thresholds That Can Raise Taxes or Premiums
Social Security benefits can be taxed, and Medicare premiums can be increased if IRA withdrawals, Roth conversions, pension income, capital gains, and dividend income contribute to your income. It is best to determine how much of the money from these sources will be declared as income.
It is not always possible to avoid every tax threshold. Solid planning with a qualified professional should give you a good idea of when and how to manage your retirement and non-retirement assets.
Manage Investment Gains and Charitable Giving
Taxable investment accounts offer opportunities to reduce, or at least better manage, your taxes when these assets are sold, donated, or rebalanced.
To maximize your ability to save on taxes, you must maintain and review the cost basis, unrealized gains, unrealized losses, and income distributions BEFORE selling investments to generate income.
If you have the desire to donate to charitable organizations, there are methods to do so that are tax advantageous to you. A Qualified Charitable Deduction allows you to donate your retirement assets (up to a maximum) and not have to pay income tax on that amount.
Capital Gains and Losses
When you sell an investment for a gain, you will most likely be responsible for capital gains tax. Conversely, if you sell an investment for a loss, you will be able to claim a loss. In general, a capital loss can offset a capital gain.
By spreading your capital gains over the course of several years, you should be able to avoid a large capital gains tax bill. That is why it is prudent to have a plan when selling assets that have appreciated.
Tax-loss harvesting, the method of selling investments that have depreciated, should be done to support your investment plan.
Qualified Charitable Distributions
Qualified Charitable Distributions (QCD) allow you to send money from your IRA directly to a charity and not be taxed on the amount that you sent. It is a highly tax-efficient way to donate money to a qualified charity.
For those who must take money from their IRA but do not need it, a QCD is the ideal way to take an IRA withdrawal without paying income tax on the amount.
Review the Tax Plan Before the Year Ends
Many tax-saving retirement decisions must be made before the end of the calendar year. Therefore, do not wait until the last minute to do this.
Year-end tax planning can be vital when coordinating withdrawals from several retirement plans, as well as Roth conversions, charitable giving, tax-loss harvesting, and estimated tax payments.
Revisiting your tax plan is prudent after the following occur: spouse’s death, Medicare enrollment, sale of a home, stock market decline, and a major change in your spending.
It is a nice experience to reduce your tax burden, but it requires constant vigilance in reviewing your situation. This is an ongoing task, not a one-and-done decision.
How to Reduce Taxes on Your Retirement Income FAQs
1. How can I reduce taxes on my retirement income?
To reduce taxes on your retirement income, strategically sequence your withdrawals across different account types, utilize tax-free Roth distributions, manage required minimum distributions (RMDs), and consider relocating to a tax-friendly state. Managing the mix of your income sources helps keep you in a lower tax bracket.
2. Which retirement accounts should I withdraw from first?
Traditionally, the standard approach is to withdraw from taxable brokerage accounts first, then tax-deferred accounts (like a Traditional IRA or 401(k)), and save tax-free Roth accounts for last. However, the most tax-efficient strategy depends heavily on your specific tax bracket, age, and future Required Minimum Distributions.
3. Are Social Security benefits taxable in retirement?
Yes, many retirees do pay federal income tax on their Social Security benefits. Whether you pay depends on your filing status and your “combined income,” which is your adjusted gross income, plus any tax-exempt interest, plus half of your annual Social Security benefits.
4. Can Roth conversions lower taxes in retirement?
Roth conversions can lower your overall lifetime tax burden in retirement by trading a larger tax bill today for tax-free growth and withdrawals later. They are most effective when done during low-income years—such as the gap between retiring and starting Social Security or required minimum distributions (RMDs)
5. How do required minimum distributions affect retirement taxes?
Required minimum distributions (RMDs) increase your annual gross taxable income because the IRS taxes these mandatory withdrawals from traditional IRAs and 401(k)s as ordinary income. This extra income can raise your tax bracket, make more of your Social Security benefits taxable, and trigger higher Medicare Part B and D premiums.
6. Can charitable giving reduce taxes on retirement income?
Yes, charitable giving can significantly reduce taxes on retirement income, most notably by lowering taxable adjusted gross income and satisfying mandatory withdrawals from retirement accounts.
Build a Tax-Smart Retirement Income Plan
Reducing your taxes on retirement income is possible, but it requires planning and continual review of your situation. How you withdraw from your accounts, when you withdraw from your accounts, Social Security benefits, Roth conversions, taking from taxable accounts, and charitable giving all feed into the equation.
Financial planning helps you estimate your after-tax income, which is what matters most. It can also help you make smart decisions about taxes before you actually make them. The wrong decision can cost you by overpaying your taxes.
The goal of this article is not to show you how to eliminate taxes when taking distributions from your retirement plan(s); the goal is to help you keep more of your retirement dollars by using all available means to reduce the tax burden associated with accessing your retirement accounts. Schedule a consultation with our team today.
For over 40 years, Retirement Solutions has been assisting women to view their financial future with anticipation rather than apprehension. We do that by empowering our clients through education. We believe that an educated client can make sound financial decisions. As a way to introduce our services, we offer a no-obligation, no-cost 15-minute telephone conversation to determine your current situation and whether we can help you get to where you want to be financially. Simply click the link in the upper right-hand corner of the Home page of the website: “Let’s Discuss Your Financial Future”. You talk, we listen.