When you retire, your income sources change, and managing your taxable income becomes an important part of your financial plan. The goal is to optimize your tax situation so that you can maintain your desired lifestyle while minimizing your tax burden. Below are some strategies that can help you manage taxable income during retirement.
1. Understand the Sources of Your Retirement Income
Your retirement income could come from several sources, each taxed differently:
Social Security: Up to 85% of your Social Security benefits may be taxable, depending on your total income.
Traditional IRAs and 401(k)s: Withdrawals from these tax-deferred accounts are fully taxable as ordinary income.
Roth IRAs: Qualified withdrawals are tax-free, but contributions were made with after-tax dollars.
Pensions: Typically taxed as ordinary income.
Investment Income: Income from stocks, bonds, and dividends may be taxed at different rates (long-term capital gains, qualified dividends).
Annuities: The taxable portion of annuity withdrawals is subject to ordinary income tax.
Understanding the tax treatment of each income source will help you make informed decisions about how much to withdraw from each in retirement.
2. Create a Withdrawal Strategy
When planning how to take withdrawals, consider the following strategies to manage your taxable income:
a. Prioritize Tax-Free or Tax-Deferred Accounts
Roth IRA: If you have a Roth IRA, consider withdrawing from this account first (after meeting any minimum requirements). Since Roth withdrawals are tax-free, you can avoid adding taxable income.
Tax-Deferred Accounts (Traditional IRAs and 401(k)s): Withdraw from these accounts later in retirement, as they’ll be taxed as ordinary income. By delaying these withdrawals, you reduce the amount of taxable income you generate in the early years of retirement when you may be in a lower tax bracket.
b. Manage Your Required Minimum Distributions (RMDs)
After age 73 (or 72, depending on when you were born), you must begin taking Required Minimum Distributions (RMDs) from tax-deferred retirement accounts like Traditional IRAs and 401(k)s. Since RMDs are taxable, it’s important to plan ahead to avoid spikes in taxable income when you must take these withdrawals.
One way to reduce the impact of RMDs is to:
Convert to Roth IRAs: Roth conversions (using funds from a traditional IRA or 401(k) to fund a Roth IRA) can be a good strategy for lowering future RMDs, but you’ll need to pay taxes on the converted amount.
Donate to Charity: If you are charitably inclined, consider using a Qualified Charitable Distribution (QCD) to satisfy part of your RMD. This allows you to donate up to $100,000 annually to charity directly from your IRA without paying taxes on that amount.
3. Use Taxable Investment Accounts Strategically
When withdrawing funds from your taxable investment accounts (e.g., brokerage accounts), be mindful of capital gains taxes:
Tax-Advantaged Investments: Consider holding tax-advantaged investments (such as municipal bonds) in taxable accounts. These investments may provide tax-free income at the federal level (and possibly state and local levels, depending on the state).
Capital Gains Tax: If you need to sell stocks, bonds, or other investments in taxable accounts, try to take advantage of long-term capital gains tax rates. If you've held the investment for over a year, you’ll pay a lower rate on your gains (0%, 15%, or 20%, depending on your taxable income).
Tax Loss Harvesting: If you have losing investments in taxable accounts, you can sell them to offset gains from other investments, which can reduce your taxable income. This is known as tax loss harvesting.
4. Take Advantage of the Standard Deduction
Retirees may find that they qualify for the standard deduction, which can reduce your taxable income significantly:
For 2023, the standard deduction for single filers is $13,850 and $27,700 for married couples filing jointly.
If your deductions are lower than the standard deduction, it makes sense to take the standard deduction, which will lower your taxable income.
However, if you have significant deductible expenses (e.g., medical expenses, mortgage interest, charitable donations), it might be worth itemizing deductions instead.
5. Minimize Taxable Social Security Benefits
Social Security benefits are taxed based on your total income, including withdrawals from retirement accounts. To minimize taxes on Social Security, you can:
Control Your Other Income: If possible, reduce taxable income by withdrawing from tax-free accounts like Roth IRAs or tax-deferred accounts strategically.
Delay Social Security Benefits: Delaying Social Security benefits until age 70 can increase your monthly payments and reduce the years in which you may be taxed on Social Security income. This can be especially helpful if you can live off other retirement assets in the meantime.
6. Be Mindful of Your Tax Bracket
As you begin withdrawing retirement funds, keep a close eye on your marginal tax bracket. The goal is to avoid pushing your income into a higher tax bracket unnecessarily.
Consider withdrawing funds early in retirement to fill up a lower tax bracket before you begin receiving RMDs or other income sources that could increase your taxable income.
You may also want to consider Roth IRA conversions in years when your income is lower, as this allows you to pay taxes at a lower rate than you might pay in future years.
7. Consider a Longevity Annuity or a Laddered Annuity
Annuities can provide a guaranteed income stream throughout retirement and may help you manage taxable income:
A longevity annuity starts payouts at a later age, which may help manage taxable income in early retirement years.
A laddered annuity involves buying multiple annuities that start payouts at different times, giving you flexibility in managing your income and taxes.
8. Utilize Health Savings Accounts (HSAs)
If you’re eligible for a Health Savings Account (HSA) and haven’t yet tapped into it, consider using it as a way to offset healthcare costs in retirement. Withdrawals for qualified medical expenses are tax-free, and funds roll over year after year. Using an HSA in retirement can help reduce the taxable income generated from other sources.
9. Be Strategic About Pension Withdrawals
If you receive a pension, your pension income is subject to ordinary income tax. Here are some tips for managing pension income:
If your pension is taxable: Consider timing your withdrawals from taxable accounts in such a way that you don't go into a higher tax bracket.
Pension and Social Security Coordination: If you receive a pension and Social Security benefits, coordinate your withdrawals so that your taxable income doesn't increase too much and make a larger portion of your Social Security benefits taxable.
10. Stay Informed About Tax Law Changes
Tax laws can change, and new tax incentives or strategies may be introduced. For example, the SECURE Act and the SECURE Act 2.0 brought changes to RMD rules and other retirement account guidelines. Keeping up with changes allows you to take advantage of new opportunities to minimize taxes.
Conclusion
Managing taxable income in retirement is essential for maintaining your desired standard of living while minimizing taxes. By understanding the various income sources, using tax-efficient withdrawal strategies, and leveraging tax-deferred and tax-free accounts, you can help ensure that you’re in the best possible position for a tax-efficient retirement. Additionally, working with a financial planner or tax professional can provide personalized advice tailored to your unique situation.