You can minimize your taxes during your retirement years with a few retirement tax strategies, but there are also ways you can lay the groundwork in the years before your retirement so that you can pay less in taxes at that time. It all begins with understanding how your various sources of retirement income will be taxed, including your Social Security benefits.
- Your income in retirement, and where it comes from, will affect how you will be taxed.
- For long-term planning, look at how much you should withdraw from your different types of retirement accounts each year and how to coordinate those amounts with your Social Security income to reduce taxes.
- You should also examine your annual tax bracket, as that will influence which type of account it will benefit you to withdraw from and whether you should take advantage of realized capital losses.
- By combining short-term and long-term tax planning, you can reduce your overall tax burden and keep more of your funds for retirement.
Who Benefits Most from Tax Planning?
The opportunity to pay less in taxes is greatest for:
- Those who have savings in both tax-deferred retirement accounts, such as 401(k) plans or individual retirement accounts (IRAs), and after-tax savings, such as a brokerage account.
- Those who have years where their income might be less, such as when one spouse retires mid-year, when spouses retire during different years, when either spouse goes through a period of unemployment, or when income fluctuates due to a commission-based job.
- Those who have years where their itemized deductions can change, such as by taking on a new mortgage, paying off a mortgage, experiencing a year with increased medical expenses or charitable deductions, or acquiring a new dependent
The total of your itemized deductions might not work out to more than the standard deduction you're entitled to for your filing status. It would be counterproductive to itemize in this case because you'd be paying tax on more income than you have to.
How Retirement Taxes Are Calculated
The factor that's most often overlooked in retirement planning is the way in which your Social Security benefits will be taxed. Careful tax planning prior to retirement can give many future retirees an opportunity to reduce the amount of their Social Security benefits that will be taxed. Taxation of benefits is governed by federal guidelines.
Up to 50% of your benefits might be taxable as of tax year 2021 (the return filed in 2022) if you have income—including half your benefits—between $25,000 and $34,000 if you're single, head of household, or a qualifying widow(er). This rule also applies to some married taxpayers who file separate returns if they did not live with their spouse at any time during the tax year. It can increase to 85% of your benefits if your income, including half of your benefits, is more than $34,000.
Married taxpayers who file joint returns are taxed on 50% of their benefits on total income between $32,000 and $44,000, and on 85% if their income is more than $44,000.
The $34,000 limit increases to $44,000 if you're married and if you and your spouse file a joint return.
By adjusting when you take your income and how much of it to take, you can gain greater control over your taxes. Jim Blankenship, CFP, shows an example of how this works in his book, "A Social Security Owner's Manual." He shows how one retiree pays thousands less in taxes by rearranging when and how they take their different sources of retirement income. It can be helpful to read up on case studies to see how you compare. You can then take necessary actions before retirement.
Tax Planning Saves Money
Two types of tax planning can help you reduce retirement taxes and increase your after-tax retirement income:
- Long-range tax planning provides general guidance as to how much you should withdraw from which accounts from year to year, and how to coordinate your sources of income with your Social Security benefits to deliver more after-tax income.
- Annual tax planning addresses how tax rates and deductions can change each year. Annual tax planning that's done in the fall can uncover tax planning opportunities that wouldn't be discovered with long-range tax planning alone.
Long-Range Tax Bracket Planning
Long-range tax planning looks at your projected tax rates and sources of income. It shows how you might rearrange your sources of income to deliver more after-tax income.
This type of planning requires software or a spreadsheet that contains detailed tax calculations to show you the amount of after-tax income you can have by taking one course of action versus another. Long-range tax planning helps reduce your retirement taxes in two ways:
- You can design a general strategy about when to withdraw money from which types of accounts to keep you in the lowest tax bracket possible.
- It can show you how to allocate investments across your tax-deferred vs. after-tax accounts to reduce your tax burden over your retirement years.
Annual Tax Bracket Planning
Annual tax planning can help you uncover opportunities to:
- Withdraw money from an IRA or convert Traditional IRA funds to a Roth IRA, and pay little to no tax in years when your deductions are high and your other sources of income are low.
- Realize capital losses to offset capital gains or create a capital loss carryover.
- Use years with high itemized deductions to your advantage.
- Fund the type of account—Roth IRA, Traditional IRA, or 401(k)—that will provide the most long-term tax benefit to you based on your tax situation in that year.
Get Help With Retirement Tax Planning
It's difficult to do smart tax planning without professional assistance. Remember when you seek help that many people who call themselves financial advisors work for big investment firms or banks that prohibit them from offering tax advice.
Find either a certified public accountant (CPA) or tax professional who has their PFS designation and does the type of long-range tax planning you're looking for, or a retirement planner who practices independently. They should have a background in taxation and a process in place to identify tax-planning opportunities. "PFS" designates a credentialed personal financial planner or personal financial specialist.
Frequently Asked Questions (FAQs)
What's the best way to save on taxes in retirement?
Understanding the sources of income you'll have during your retirement and how they are taxed will be your first step to saving on taxes at that time. While you won't know exactly what your tax rate will be when you retire, as tax laws and your actual income are subject to change, making an educated guess as to your future income bracket will help. For example, in 2022, marginal tax rates range from 10% for incomes below $10,275 to 37% for incomes above $539,900. Those income limits are subject to inflation adjustments each year.
Once you know those factors, you can look closely at your taxable and nontaxable income and your deductions. That information will help when projecting where it will be most tax-efficient to put your funds as well as when to take distributions and how much. A tax professional can help you run these numbers.
How should you estimate your future tax bracket in retirement?
That depends on how you expect your income to change. If you're early in your career and not earning much, you may be in a higher tax bracket at retirement. On the other hand, if you're already in a high bracket, stopping work at retirement may lower your income and drop you to a lower tax bracket.