You’ve outlined your budget and built up a substantial investment portfolio. You have run calculations to see how much you should be able to safely spend in retirement. But have you thought through the tax implications? It’s very common for tax planning to be overlooked. Most simply think their taxes will go down. Others don’t realize the majority of their Social Security will be taxed. In fact, a recent study found that 57% of Americans rarely consider the taxes they will pay in retirement.1 This can be an expensive mistake and it can impact other retirement benefits.
A New Tax Landscape
Depending on your income sources, up to 85% of your Social Security may be taxable. Yes, you may owe more taxes on the money withdrawn from your paycheck over your career. Withdrawals from 401(k)s and Traditional IRAs are taxable since they were funded before taxes. You also owe taxes on your brokerage accounts from dividends, interest income, and capital gains.
Your new retirement tax bracket is derived from your combined income. This is your adjustable gross income, nontaxable interest income, and some portion of your Social Security. If your income is high enough, you may have to pay a premium over regular rates for Medicare Part B.
Lifestyle Tactics to Lower Your Tax Bill
The first step to reducing your potential tax bill is to lower your income needs. To do this, many people try to pay off their mortgage before retirement. This means you won’t have to withdraw as much income, which will lower your tax liability. This may require some rejiggering of budgets or putting off discretionary expenses during the last years of working, but the advantage over the course of your retirement may be worth it.
Moving to a different state in retirement may allow you to pay less in taxes. This may be lower state income taxes and some states don’t tax retirement income.
If you’re planning to make charitable contributions, consider lumping a few years of donations into a Donor Advised Fund. If you’re 70 and a ½ or older, it may make sense to give directly from your traditional IRA. This may be a great way to use your Required Minimum Distributions (RMDs) starting at 72.
Investment Strategies for Managing Income
Asset allocation is a strategy for diversifying your accounts across investment types. Asset location refers to a strategy for placing investments in accounts where they have the potential to lower your tax liability.
Taxable accounts, such as brokerage accounts, should hold tax-efficient investments. These include stocks you will hold for more than a year; tax-exempt municipal bonds; and index funds. Tax-deferred accounts are better for tax-inefficient investments. These include fixed income, commodities, some alternatives, and other actively managed strategies.
If you have a Roth IRA from which you can withdraw tax-free, along with a traditional IRA, you may want to be thoughtful about your total income picture when determining which account to withdraw from. Taking from the appropriate account based on whether your income is likely to be higher or lower in a given year can lower taxes.
Converting to a Roth IRA may also be a good strategy, but you’ll need to think through when and how much you’ll convert, or your upfront tax bill will be quite large. Staggering the conversion over several years can make it more manageable.
The Bottom Line
Retirement planning doesn’t stop with creating a strategy to generate the income you want. Instead, it continues with thinking through the tax implications. There are a number of tactical moves to keep income as tax-advantageous as possible.
- The 2021 Nationwide Retirement Institute Tax-Efficient Retirement Income Survey. The Harris Poll. March 25, 2021.