You can minimize your taxes during your retirement years with a few retirement tax strategies, but there are also ways in which you can lay the groundwork in the years or before your retirement so you can pay less in taxes at that future time. It all begins with an understanding of how your various sources of retirement income will be taxed, including Social Security benefits.
Best Circumstances for Tax-Planning
The opportunity to pay less in taxes is greatest for individuals who:
- Have savings in both tax-deferred retirement accounts, like 401(k) plans or IRAs, and after-tax savings, such as a brokerage account
- 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
- 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 if you have income—including half your benefits—between $25,000 and $34,000 in 2020 if you're single, head of household, or a qualifying widow(er). This rule also applies to some married filing separately taxpayers. It can increase to 85% of your benefits if your income including half of your benefits is more than $34,000.
The $34,000 limit increases to $44,000 in 2020 if you're married and if you and your spouse file a joint return.
Jim Blankenship, CFP shows an example of how this works in his book, "A Social Security Owner’s Manual." One retiree pays about $96,000 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 IRA money 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 or 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 CPA or tax professional that has their PFS designation and actively does the type of long-range tax-planning you're looking for, or a retirement planner that 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.