Tax Planning Strategies for Retirees

Tax liability can depend on the source of your retirement income

Couple using tablet computer in retirement home
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Planning ahead can go a long way toward keeping your taxes as manageable as possible when you reach your retirement years, but it can seem like a bit of a challenge if you don't understand all the options available to you. When you understand how your retirement income will be taxed, you can choose the right strategies to keep your tax bill as low as possible. Retirees have some control over their tax situations because they can decide how much they want or need to withdraw from their various retirement plans.

Deductions and Exemptions 

Take full advantage of standard or itemized deductions and personal exemptions. All these help determine how much of your income will be tax-free. Retirees can coordinate taxable distributions with their mortgage payments, real estate taxes, and medical expenses.

Accelerate Retirement Contributions 

Consider accelerating retirement distributions if you have a lot of available deductions. You might withdraw more retirement funds than you need in a year when your deductions exceed your taxable income. You'll avoid potentially paying more taxes in a future year if you take more sizable withdrawals now, with a have zero or a low tax rate, rather than later. 

Defer Retirement Plan Distributions 

The flip side to this strategy is to defer your retirement plan distributions until you need them or they become required by tax law. Keeping taxable distributions to a minimum pushes more income to future tax years if you expect you'll fall into a lower tax bracket at that time. 

Taxpayers must begin withdrawing funds from their 401(k)s and traditional IRA plans when they reach age 70 1/2. Distributions must start by April 1 of the year following the year in which they reach that birthday. This is called the "required beginning date." The minimum amount that must be distributed is your account balance divided by the life expectancy figures published by the IRS in Publication 590. You can use web-based calculators to estimate your required minimum distributions. Plan to withdraw at least the minimum amount required from your IRA and 401(k) accounts.

Roth IRAs and designated Roth 401(k) accounts are exempt from the required minimum distribution rules. 

The Tax Credit for the Elderly 

Don't overlook the Credit for the Elderly. This special tax credit can be claimed by taxpayers who are age 65 or older, but qualifying for it requires careful planning—your adjusted gross income must fall beneath certain limits.

Maximize Your Tax-Free Income

Taxpayers can exclude up to $250,000 from capital gains tax when they sell their main home. This figure doubles to $500,000 if you're married. Interest earned from municipal bonds is also exempt from tax.

How Retirement Income Is Taxed

Retirees often receive income from a variety of sources, including Social Security benefits and distributions from pensions, annuities, IRAs and other retirement plans. Each is subject to slightly different tax rules.

Social Security 

Your Social Security benefits might be completely tax-free or partially tax-free depending on your overall income from all sources. Figuring out how much of your benefits will be included as taxable income involves some math, but it's worth doing for planning purposes and you'll have to make the calculations anyway at tax time.

Pension or Annuity Income 

Your pension or annuity income might be either fully or partially taxable.

Your distributions will be fully taxable if all contributions to your pension were made with tax-deferred dollars. But if you contributed any after-tax dollars to fund your plan, you'll have some cost basis in the plan contract. Part of your distributions will be a tax-free recovery of that cost basis and only the remainder will be taxable income.

IRS Publication 575, Pension and Annuity Income, provides comprehensive information about figuring out the taxable amount, but your plan administrator should be able to calculate the taxable portion of your pension distribution for you. Contact the administrator to find out what your pension payments will be and what part of those payments will be considered taxable.

IRA Distributions 

Distributions from your individual retirement account might also be fully taxable, partially taxable, or completely tax-free. It depends on the type of IRA you have. If you have a deductible traditional IRA, your distributions will be fully taxable. You contributed funds using tax-deductible dollars, and tax is deferred on both the contributions and the earnings until they are withdrawn.

If you have any basis in a non-deductible traditional IRA, your distributions will be partially taxable. A portion of your distribution represents a return of your non-deductible investment and that portion is recovered tax-free.

Distributions from Roth IRAs are completely tax-free as long as you meet two basic requirements: Your first Roth IRA contribution was made at least five years prior to any distribution, and the funds are distributed after you reach age 59 1/2. 

401(k) Plans 

Distributions from your employer's 401(k) plan are fully taxable because the contributions were excluded from your taxable income at the time they were made. Distributions from Roth 401(k) accounts are treated the same as Roth IRA distributions.