When you’re planning for retirement, it’s easy to focus on how much you’ll need to save and what your income will be, but taxes often get overlooked. Many people assume that taxes will be lower in retirement because they’re no longer working, but this isn’t always the case. In fact, if you don’t plan for taxes, you may end up paying more than you expected.
In this blog, we’ll explain how to plan for taxes in retirement so you can keep more of your hard-earned savings.
Understanding Taxable Income in Retirement
Before you can plan for taxes in retirement, it’s important to understand where your income will come from and how it will be taxed. In retirement, your income may come from several sources, including:
- Social Security
- Pension payments
- Withdrawals from retirement accounts like 401(k)s or IRAs
- Investment income (dividends, interest, capital gains)
- Rental income or other side income
Each of these income sources may be taxed differently, and the amount you’ll pay depends on your overall taxable income. Let’s break down the most common sources of income in retirement and how they’re taxed.
Social Security
Many people rely on Social Security for a portion of their retirement income. While Social Security benefits may not be fully taxable, up to 85% of your benefits can be taxed if your income exceeds certain thresholds.
- If your income (including half of your Social Security benefits) is more than $25,000 for single filers or $32,000 for joint filers, you may have to pay taxes on part of your benefits.
Understanding how your Social Security benefits are taxed will help you plan withdrawals from other sources to minimize the amount of tax you owe.
Withdrawals from Retirement Accounts
Withdrawals from traditional retirement accounts like 401(k)s and IRAs are taxed as ordinary income. This means that any money you take out will be added to your total income for the year and taxed at your marginal tax rate.
If you have a Roth IRA or Roth 401(k), however, the money you withdraw in retirement is tax-free, as long as you’ve had the account for at least five years and are over the age of 59½. This is one reason why Roth accounts can be a great tool for tax planning in retirement.
Investment Income
If you have investments outside of retirement accounts, you may earn income from dividends, interest, or capital gains.
- Dividends and interest are generally taxed at ordinary income tax rates.
- Long-term capital gains (profits from selling investments held for more than a year) are taxed at lower rates—typically 0%, 15%, or 20%, depending on your income.
By planning how and when to sell investments, you can reduce the taxes you owe on capital gains.
Strategies for Reducing Taxes in Retirement
Now that you know what’s taxed in retirement, let’s look at some strategies you can use to minimize your tax burden and keep more of your savings.
1. Roth Conversions
One way to reduce taxes in retirement is by converting money from a traditional IRA or 401(k) to a Roth IRA before you retire. This process is known as a Roth conversion. When you convert to a Roth IRA, you’ll pay taxes on the amount you convert in the year of the conversion, but the money will grow tax-free, and withdrawals in retirement won’t be taxed.
Why this strategy helps:
- If you expect to be in a higher tax bracket in retirement, paying taxes now on the conversion may save you money later.
- Roth IRAs don’t require required minimum distributions (RMDs), so you can leave the money in the account to grow tax-free for as long as you want.
Roth conversions can be especially useful during years when your income is lower, such as if you’ve already retired but haven’t yet started taking Social Security or other retirement distributions.
2. Withdraw Strategically from Multiple Accounts
If you have a combination of taxable, tax-deferred, and tax-free accounts, you can use a strategy called tax diversification to minimize the taxes you owe in retirement.
Here’s how it works:
- In the early years of retirement, withdraw from taxable accounts or Roth IRAs, where the money is taxed at lower rates or not taxed at all.
- Later in retirement, when you’re required to take RMDs from traditional IRAs or 401(k)s, you’ll be in a better position to control your taxable income and possibly pay lower taxes overall.
By spreading out your withdrawals across different accounts, you can avoid pushing yourself into a higher tax bracket and reduce the total taxes you owe.
3. Delay Social Security Benefits
One strategy for reducing taxes in retirement is to delay claiming Social Security benefits until after you’ve started withdrawing from your tax-deferred accounts. The longer you wait to claim Social Security (up to age 70), the higher your monthly benefit will be, and you may have fewer taxable withdrawals to make.
Additionally, if you delay Social Security until your other taxable income is lower, you may pay less in taxes on your benefits.
4. Use Qualified Charitable Distributions (QCDs)
If you’re over age 70½ and plan to make charitable donations, you can use a strategy called qualified charitable distributions (QCDs). With a QCD, you can transfer up to $100,000 per year directly from your IRA to a charity, and the amount will not be included in your taxable income.
Why it’s beneficial:
- QCDs count toward your required minimum distributions (RMDs), so you can reduce your taxable income while supporting causes you care about.
This is a great way to reduce taxes if you’re already required to take RMDs but don’t need the money for living expenses.
5. Plan for Required Minimum Distributions (RMDs)
If you have a traditional IRA or 401(k), you’ll need to start taking required minimum distributions (RMDs) once you turn 73 (for those born after 1950). These withdrawals are taxed as ordinary income, so it’s important to plan ahead to avoid a large tax bill.
Tips for managing RMDs:
- Start taking small withdrawals from your traditional accounts in your early 60s to reduce the amount subject to RMDs later.
- Consider Roth conversions during lower-income years to reduce the size of your traditional accounts.
By carefully planning how you take RMDs, you can spread out the tax burden and avoid a significant tax hit in one year.
6. Work with a Financial Advisor
Navigating the complexities of taxes in retirement can be challenging, especially as you juggle multiple income sources, tax rates, and strategies. A financial advisor can help you develop a tax-efficient retirement plan that ensures you’re making the most of your savings while minimizing taxes.
Benefits of working with an advisor:
- Advisors can help you determine when to take Social Security, how to structure withdrawals from retirement accounts, and how to implement tax-saving strategies like Roth conversions.
- They can also help you navigate tax changes and adjust your plan as needed.
A good financial advisor will help you build a comprehensive tax plan that aligns with your retirement goals.
Conclusion
Planning for taxes in retirement is essential to making sure your savings last and that you can maintain your desired lifestyle. By understanding how your income will be taxed and using strategies like Roth conversions, strategic withdrawals, and QCDs, you can significantly reduce your tax burden. Working with a financial advisor can help you navigate the complexities of retirement taxes and develop a personalized plan that fits your unique financial situation.
With the right planning, you can keep more of your savings, minimize your tax bill, and enjoy a financially secure retirement.
