Retirement is a time to enjoy the fruits of your hard work and live the life you’ve always dreamed of. But it also comes with some tax challenges you must know and plan for. In this article, we’ll share some tips and strategies for minimizing taxes in retirement, including how to manage required minimum distributions (RMDs) and maximize tax-advantaged accounts.
Live in a Tax-Friendly State
Living in or relocating to a state with low or no income taxes is one of the best methods to reduce taxes during retirement. According to Investopedia, eight states, including Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming, do not impose income taxes. Dividends and interest are taxed solely in Tennessee and New Hampshire.
By dwelling in a tax-friendly jurisdiction, you can avoid paying hundreds of dollars in state income taxes yearly. It is also possible to get around the $10,000 cap on state and local tax deductions for federal income tax resolutions imposed by the Tax Cuts Act of 2017.
You won’t have to pay taxes on your retirement income received from another state if you reside in a tax-friendly state. According to federal law, states are not allowed to tax people’s retirement benefits from another state. As a result, you wouldn’t be required to pay state taxes on your pension income if you retired in Florida or Texas instead of California or New York (states with high taxes) and received your pension in those states.
The cost of living, access to healthcare, the local climate, and quality of life are all important considerations when deciding where to live in retirement. But if paying taxes causes you a lot of anxiety, it might be worthwhile to consider moving to a state with lower taxes.
Consider Your Investments Again
Another way to save taxes in retirement is to reassess your investment portfolio and ensure it aligns with your goals and risk tolerance. You can also make some changes to optimize your portfolio for tax efficiency. Here are some ideas:
Municipal bonds
Federal income tax is not applied to interest on municipal bonds. However, it might impact how taxable your Social Security welfares are. 2 Municipal bonds may offer a consistent income stream without raising your taxable income or placing you in a higher tax bracket.
Dividend stocks
Dividends are payments made by businesses from their profits to their shareholders. Qualified dividends are taxed lower than ordinary income if you receive them from American or specific foreign corporations. The tax rate could be zero, 15%, or 20%, depending on your taxable income. 3 Dividend stocks may provide both growth potential and advantageously taxed income.
Capital losses
You incur losses when you sell an investment for less than what you paid. You can use capital losses to offset capital gains, profits you make when you sell an asset for more than what you paid. If you have more capital losses than capital gains in a year, you can use up to $3,000 of the excess losses to reduce your ordinary income. Any remaining losses can be carried forward to future years. 4 Capital losses can help you lower your tax bill by reducing your taxable income or eliminating your capital gains tax liability.
Tax-efficient investing
Tax-efficient investing is a strategy that involves choosing investments that generate less taxable income or gains or holding them in accounts that defer or eliminate taxes. For example, you can hold investments that produce a lot of interest or dividends, such as bonds or REITs, in tax-deferred accounts like IRAs or 401(k)s. This way, you can postpone paying taxes on the income until you withdraw it in retirement. On the other hand, you should hold investments that appreciate over time, such as stocks or ETFs, in taxable accounts like brokerage accounts. This way, you can benefit from the lower tax rates on long-term capital gains when you sell them.
Manage Your Required Minimum Distributions
The money you must withdraw from your traditional IRAs and 401(k)s each year when you age 72 (or 70 1/2 if you were born before July 1, 1949) is known as required minimum distributions (RMDs). Depending on how much money you have in your accounts and how long you are anticipated to live, the IRS will inform you how much you need to withdraw. To calculate your RMDs, you can use a calculator or the IRS tables.
RMDs are taxed as regular income, so they can increase your taxes and put you in a higher tax bracket. To avoid this, you should take out more money in some years when your income is low or when you have things that can lower your taxes, like deductions or credits. Change some of your traditional accounts to Roth accounts, which do not have RMDs, and let you take out money tax-free. But you must pay taxes when changing your charges, so make sure it is worth it.
Another thing to remember is that if you do not take out your RMDs on time, you will have to pay a significant penalty of half of the money you should have taken out. Set up automatic withdrawals from your accounts or use a reminder system to avoid this. You can also ask the IRS to forgive the penalty if you have a good reason for missing the deadline.
Conclusion
Taxes are inevitable in retirement, but they don’t have to ruin your financial plan. By following some of the tips and strategies we’ve discussed, you can minimize your tax burden and keep more of your hard-earned money. Some of the key steps you can take are:
- Living in a tax-friendly government or moving to one
- Make your investments more tax-efficient by reevaluating them.
- Managing your required minimum distributions and avoiding penalties
- Converting to Roth accounts and withdrawing tax-free income
- Investing in tax-efficient funds and asset allocation
- Giving to charity and claiming tax deductions
Remember, tax planning is not a one-time event but an ongoing process that requires regular review and adjustment. Consider consulting a tax professional or a financial advisor who can help you with your specific situation and goals. Being proactive and innovative about your taxes allows you to enjoy a more comfortable and secure retirement.
