8 simple ways to reduce taxes in retirement
For most Americans, taxes are an unwelcome fact of life. But taxes in retirement might be a shock to someone who assumed that, after a lifetime of paying taxes, retirement would be an exception. Do you know what your tax obligation will look like after you retire?
The tax situation for most retirees is complicated. Whether you’ll owe taxes on withdrawals from your retirement accounts can depend on many factors, including:
- The type of retirement accounts you have
- Whether you already paid taxes when you made your contributions
- Your total annual income
- How much you withdraw from your accounts
If you’re a current or future retiree wondering how to reduce taxable income in retirement, here’s a look at popular retirement accounts, their tax implications and what you can do to minimize your taxes in retirement.
Which investments can reduce your tax bill?
Sooner or later, you’re probably going to pay taxes on your retirement savings. The question is whether you’ll pay them on your contributions to those accounts or pay them on your withdrawals. Here’s more:
Roth IRAs and Roth 401(k)s
When you take money out of your Roth IRA (Individual Retirement Account) after age 59½, you generally pay no tax on the withdrawals—because you’ve already paid taxes on your contributions during your working years. However, it's important to note that Roth IRAs have income limitations that can affect your eligibility to contribute. But for those who are eligible, can a Roth IRA reduce taxable income during the withdrawal phase? The answer is, yes! This is why considering a Roth IRA in your investing years is generally good retirement advice. It enables your retirement investment to grow tax-free for years. Then, when you’re retired and have little or no working income, your Roth IRA withdrawals can work harder for you because you don’t lose a bite to taxes. Some employers offer “Roth 401(k)s” that work on this same principle.1
Bottom line: These investment accounts can reduce your taxes in retirement.
Traditional IRAs and 401(k)s
Contributions to pre-tax plans like traditional IRAs and 401(k)s can reduce the taxes you owe during your working years (i.e., when you contribute), but they don’t reduce your taxes in retirement. That’s because you generally don’t pay taxes on the money you contribute to your traditional IRA. However, you do pay taxes on the withdrawals (and if you take withdrawals before age 59½, you pay both tax and a penalty). These plans can work best for you if you have a high income as you work (and can use the tax break), and anticipate lower income in retirement, which will reduce the tax rate you pay on withdrawals. Traditional 401(k)s, offered by many employers, likewise work on the principle of tax-free contributions and taxable withdrawals.2
Bottom line: This investment account reduces your tax bill during your working years, but not in retirement.
Health Savings Accounts
If you’re a typical retiree, with less income and a lower tax rate in retirement, Health Savings Accounts (HSAs) can help reduce your taxes in retirement. As their name suggests, these plans primarily help you meet medical expenses, and they can do so at any time during your working or retirement life. Withdrawals for qualifying medical expenses are tax-free, before or after you retire. Withdrawals for other purposes are subject to regular income tax and, if you’re not yet 65, to a penalty.3
Bottom line: This investment account can reduce taxable income during your working years and in retirement.
Wondering what the impact of tax deferral can be on your retirement savings? Check out Jackson’s Tax Deferral Calculator.
How to reduce taxes in retirement
Consider these strategies to help reduce your taxable income in retirement:
Maximize your retirement account contributions (especially on a Roth).
Most Americans make less money in retirement than they do during their working years, so you’ll likely fall into a lower tax bracket. Combine that benefit with a Roth account where you’ve already paid taxes on those contributions, and you can reduce your taxable income in retirement.
Consider a Roth conversion.
If you already have most of your retirement investments tied up in a traditional 401(k) or IRA, you might consider a Roth conversion. That way, you can pay those taxes now and avoid them later. Talk with your financial professional about the pros and cons of converting your traditional plan to a Roth plan.
Prepare for minimum distributions.
You’ll likely need to start taking required minimum distributions (RMDs) or withdrawals from your plans at some point; most plans require them by age 73.*† Meet the minimums to avoid penalties but keep your withdrawals as low as possible to reduce the impact of taxable plans.
Make Qualified Charitable Distributions (QCDs).
Your IRA withdrawals don’t need to be for retirement expenses. If you’re at least 70½, you can make a limited annual donation to qualified charities directly from your IRA that helps make the world a better place — without adding to your taxable income.4 QCDs can satisfy your RMD requirement, meaning that you won't have to pay taxes on an otherwise taxable withdrawal that the IRS mandates you take after RMD age.
Plan your withdrawals carefully.
As in so much of life, timing is everything when it comes to taking withdrawals from your retirement accounts. You might be able to reduce your taxes in retirement by taking a mix of taxable and non-taxable amounts as this can allow you to spend the same with less tax liability and potentially reduce social security taxation.
Invest in tax-exempt bonds.
Some of the same approaches that can reduce your tax burden during your working life can also work in your retirement. For example, consider investing in tax-exempt bonds. They can provide tax-free interest at the federal level and possibly at the state level, if you buy your own state’s bonds.5
Move.
Federal taxes might be the same wherever you live in the U.S., but state taxes can vary widely from state to state. As part of your retirement plan, consider moving to a state with better climate, nearby family members — and lower taxes.
Delay Social Security benefits.
If your circumstances permit, consider delaying your Social Security benefits until you reach age 70. That can help reduce taxable income — and thus taxes — in your 60s. Plus, you’ll receive a larger monthly benefit amount if you wait until you are 70.
Be on the lookout
Nobody knows what the future may bring, but taxes are a sure thing. For example, be on the lookout for the possible elimination of taxes on Social Security, which has been proposed in Washington, D.C. The age for required minimum distributions recently went up and it could do so again, enabling you to further delay distributions and the taxes you pay on them. And changes to capital gains tax rates could impact the investment portfolios of retirees.
Your financial professional can keep you informed of these and other changes—and on how they can help reduce your taxes in retirement. Consider your financial pro as a vital resource in all your financial planning for retirement.