In your working years, most of your tax bill is determined by the size of your paycheck. Sure, you may be able to lower your tax liability by making tax-deductible retirement account contributions or deducting mortgage interest, but the major driver of tax liability is determined by the amount you earn.
Taxes are different in retirement. If you are no longer earning a salary, the taxes you will pay depend on your personal spending and where you draw income. Income can be drawn from Social Security, pensions, IRAs and Roth IRAs, to name a few. For this reason, retirees have more control over their tax bill, with the exception of required minimum distributions (RMDs), which are required at age 70.5.
Here are six ways retirees can alleviate their tax liability in retirement.
1. Diversified Tax Buckets
If you are already retired, ignore this step. If you are still working, one of the best ways to reduce your future tax liability is to invest in different tax “buckets.” These buckets include taxable, tax deferred, and tax free accounts. Yes, you can receive a deduction on contributions to traditional retirement accounts, making traditional IRAs and 401(k)s a less painful way to accumulate retirement assets. However, those assets are taxed at your ordinary income tax rate when you pull money out in retirement, and are also subject to an RMD after age 70.5. Qualified withdrawals from Roth IRAs are tax-free and securities sold from taxable accounts are eligible for long-term capital gains treatment.
2. Early and Frequent Planning
If you did not diversify your retirement accounts while you were still working, it’s not too late! During the early years of retirement it may make sense to begin converting some of your traditional IRAs to Roth IRAs prior to turning 70.5. Since you may have more control over your taxable income during these years, you may be able to convert to a Roth IRA at a more favorable tax rate compared to when you were working. This will give you more control over the amount of RMDs you are required to take at 70.5 since there are no RMDs on Roth IRAs. (For related reading, see: The Simple Tax Math of Roth Conversions.)
3. Asset Location
In an effort to reduce your tax bill, it's also wise to keep an eye on which assets you house in which accounts. Positions that pay higher levels of taxable income, such as high yield bonds, dividend paying stocks, and REITs are best suited in your tax-deferred accounts where you will only pay taxes on the income if you're withdrawing it. Meanwhile, investments that do not pay high levels of taxable income, such as non-dividend paying stocks and municipal bonds, are a better fit for taxable accounts.
4. Social Security Taxation
Today, approximately 50% of all Social Security recipients will pay at least some tax on their benefits, according to the Social Security Administration. Furthermore, several states tax Social Security benefits as well. You can use this map to see if your state includes Social Security benefits in your taxable income. Retirees should pay attention to the possibility that tax on Social Security benefits could boost their marginal tax rates. The amount of tax due on Social Security benefits is determined by your overall income, with up to 85% of your benefits being taxable. (For related reading, see: How Social Security Benefits Are Taxed.)
5. Charitable Contributions
Charitable contributions can be used to provide a tax break. You can to deduct the amount of your contribution, up to 50% of your adjusted gross income, to qualifying charities. Retirees can also take advantage of what's called a qualified charitable distribution, which can often deliver a bigger bang for your tax buck than donating IRA distributions to a charity. On the other hand, retirees with highly appreciated assets in their taxable accounts can donate investments directly to charity; the donor gets the tax burden of the appreciation off their books and the charity won't owe taxes either.
6. Estate Planning and Taxes
Lastly, while attempting to reduce your own tax liability it’s also worth considering the tax ramification of assets left to your heirs. Highly appreciated assets such as a closely held business, real estate, or highly appreciated securities held in taxable accounts can also be sensible assets to earmark for heirs; taxes on the sale of these highly appreciated assets are based on the value of the asset at your date of death, not your own cost basis. A qualified estate planning attorney can help you craft a sensible plan to reduce the taxes for you and your loved ones.
Regardless of where you stand financially there are strategies to improve your tax situation for retirement. As with most planning, the sooner you begin planning the better off you’ll be in the long run. Before implementing any changes I recommend meeting with a financial advisor, CPA and estate planning attorney. Professional financial, tax and legal advice will continue to pay for itself in dividends for the rest of your life.
(For more from this author, see: Investing for Retirement Needs, Wants and Wishes.)