You worked hard to save enough money for retirement, but that’s only part of the battle. Once you retire and rely on that money as your main income source, the last thing you want is for the government to get a big chunk of it.
Most people will enter retirement with less money than they need, so you're wise to minimize taxes. In fact, even if you have saved a lot of money, you'll still want to pay the lowest amount of taxes possible. Here are a few tips on how to pay fewer taxes to the government in retirement and save more money for you and your family.
- Paying less in taxes means adhering to a few select rules, including knowing what income is taxable, when, and at what rate.
- It may also be advantageous to convert to a Roth IRA during the years when income is low.
- Moving to a lower tax state can also be an interesting way to lower taxes.
1. Know What’s Taxable
That’s easy—just about everything is taxable. The question is, when is it taxable? If you have investments outside of tax-advantaged retirement accounts, they’re taxable each year, whether you are retired or not. These may include brokerage accounts, real estate, savings accounts, and others.
Most retirement-designated income, on the other hand, is not taxable until you actually retire. Withdrawals from traditional IRAs, 401(k)s and 403(b)s, and payments from annuities, pensions, military retirement accounts, and many others, may be taxable.
The Roth IRA, on the other hand, is a hybrid. The money you put into a Roth account is taxable before you make the deposit, but the investment gains are tax-free if you wait to withdraw them until you experience a "qualifying event."
Turning 59½ is one qualifying event; some research on your own or with the help of a financial advisor will help you figure out the others, as well as which other assets are taxable, tax-deferred, or exempt.
2. Know Your Tax Bracket
For the tax year 2020, the top tax rate is 37% for individual single taxpayers with incomes greater than $518,400 ($622,050 for married couples filing jointly). The other rates are as follows:
- 35%, for incomes over $207,350 ($414,700 for married couples filing jointly)
- 32% for incomes over $163,300 ($326,600 for married couples filing jointly)
- 24% for incomes over $85,525 ($171,050 for married couples filing jointly)
- 22% for incomes over $40,125 ($80,250 for married couples filing jointly)
- 12% for incomes over $9,875 ($19,750 for married couples filing jointly)
The lowest rate is 10% for incomes of single individuals with incomes of $9,875 or less ($19,750 for married couples filing jointly).
For 2021, the top tax rate remains at 37% with incomes greater than $523,600 ($628,300 for married couples filing jointly). The other rates for 2021 are as follows:
- 35%, for incomes over $209,425 ($418,850 for married couples filing jointly)
- 32% for incomes over $164,925 ($329,850 for married couples filing jointly)
- 24% for incomes over $86,375 ($172,750 for married couples filing jointly)
- 22% for incomes over $40,525 ($81,050 for married couples filing jointly)
- 12% for incomes over $9,950 ($19,900 for married couples filing jointly)
The lowest rate is 10% for incomes of single individuals with incomes of $9,950 or less ($19,900 for married couples filing jointly). Understanding how much tax you'll pay on income earned can help with proper planning.
3. Convert to a Roth
Remember, a Roth IRA taxes you now instead of when you withdraw the money. Paying taxes now, while you’re still working, eliminates the tax burden later in life when you need all the money you can get.
Assuming no changes to the tax code in the future, doing a Roth conversion in the years when your income is low will allow you to pay taxes at a lower tax bracket. This only works if it works out to where you'll pay taxes at a lower rate now versus if you wait until retirement to withdraw funds. The downside to this strategy is it makes a number of assumptions, notably that you can reasonably estimate your tax bracket during your retirement years.
4. Tax Diversification
Just as you should diversify your investment portfolio to avoid large-scale losses, you should do the same with your taxes because your tax bracket likely will fluctuate at various times in your life. When taxes are high, it can be useful to take income from tax-free accounts. Then, when taxes are low, vice versa—a retiree may choose to take income from a taxable account.
5. Consider Moving
Ever wonder why Florida is among the most popular destinations for retirees? It’s not just the beaches and weather, but also the lack of state income tax. Eight states in total have no state income tax—Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. New Hampshire will join that list in 2024 when it fully phases out taxes on investment and interest income.
The Bottom Line
The key to keeping your retirement taxes low is not to wait until retirement to start planning. Instead, make plans well before you need to rely on your retirement savings as your main source of income. Financial planning is no easy task. It’s best to seek the advice of a financial advisor with experience in designing tax-efficient wealth-management plans.