Learn How to Pay Less Taxes in Retirement
You can pay lesser taxes in retirement if you do smart tax planning from ages 55 to 70. The opportunity to pay less is greatest for those who:
- Have savings in both tax-deferred retirement accounts, like a 401(k) plan or IRA, and after-tax savings, like a revocable trust or brokerage account.
- Have years where income may vary, such as when one spouse retires mid-year, spouses retire during different years, either spouse goes through a period of unemployment, or income fluctuates due to a commission-based job.
- Have years where itemized deductions may vary, such as taking on a new mortgage, paying off a mortgage, a year with increased medical expenses or charitable deductions, or the taking on of a new dependent.
Understand How Retirement Taxes Are Calculated
To pay lesser taxes in retirement, you have to understand how your various sources of retirement income are taxed. The factor that is most often overlooked is the way your Social Security benefits will be taxed.
There is a formula that is used to determine how much of your Social Security benefits will be taxed. Many upcoming retirees have the opportunity to reduce the amount of their Social Security benefits subject to taxation by doing careful tax planning.
In his book, A Social Security Owner’s Manual, Jim Blankenship, CFP® shows a beautiful example of how this works. In his example, one retiree pays about $96,000 less in taxes by rearranging when and how they take their different sources of retirement income.
To reduce retirement taxes you must understand how your Social Security benefits will be taxed and read examples of case studies on how marrieds pay tax on Social Security benefits to see how you compare.
Tax Planning Saves Money
Two types of tax planning, which I call tax bracket planning, can help you reduce retirement taxes, and thus increase your after-tax retirement income:
- Long range tax planning—this 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—each year tax rates and deductions change. Annual tax planning done in the fall of each year can uncover tax planning opportunities that cannot 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 and shows you 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 you reduce retirement taxes in two ways:
- Design a general strategy about when to withdraw money from which types of accounts to keep you in the lowest tax bracket possible.
- Show you how to allocate investments across your tax-deferred vs. after-tax accounts to reduce your tax burden over your retirement years. The concept of rearranging investments to reduce taxable income provides money saving benefits.
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 where 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 Regular IRA or 401(k), that will provide that most long-term tax benefit to you based on your tax situation that year.
By doing both long range and annual tax planning, many retirees will be able to increase their after-tax retirement income by $500 - $4,000 a year. Over twenty to thirty years in retirement that adds up to $10,000 to $120,000 of additional retirement income.
Getting Help with Retirement Tax Planning
It is difficult to do smart tax planning without professional assistance. When seeking help, remember many people who call themselves financial advisors work for big investment firms or banks that prohibit them from offering tax advice.
You need to find either a CPA or tax professional that has their PFS designation and actively does the type of long range tax planning discussed in this article or a retirement planner that practices independently, has a background in tax and a process in place to identify tax planning opportunities.