How to Reduce Taxes in Retirement
If you're retired, odds are your taxes are much different than they were while you were working full-time. Since income in retirement moves from wages to diverse sources of income, understanding how to minimize your tax bill can get a little confusing. Taxes can still cut into your budget, even if you're not earning any income by working part time. However, with a little effort, you can lessen your tax liability by thousands of dollars each year.
Managing Your Part-time Income
Understand IRS rules affecting earned income in retirement.Retired people working part time are taxed at regular income rates just like everyone else. However, they also may be receiving Social Security benefits and taxable retirement income. All of these sources count towards your income in retirement and, accordingly, are used to determine your tax bracket. A retiree still working part-time may find themselves in a higher tax bracket than expected if they are receiving income from all of these sources at the same time.
Manage investments to minimize taxes.While it may seem that all investments are equal from a tax standpoint, some are taxed more heavily than others. For one, interest from debt securities (like bonds) and dividends payment from stocks are treated as income for tax purposes. However, capital gains (from the sale of securities that have appreciated in price) is taxable at a lower rate, the capital gains tax rate. To reduce taxes, redirect your investments towards stocks and mutual funds that do not pay dividends so that your earnings will be primarily made in capital gains.
- Another option is to invest in municipal bonds. These can provide you with tax-free income, but often offer less in interest payments than taxable bonds. If your tax bracket is high enough, this difference is paid for in tax savings.
- You can also invest in annuities. A portion of the money returned in annuity payments is composed of original contributions and therefore is not taxable.
Coordinate earned income with retirement income.If you plan on working part-time in retirement, you can start early by delaying your Social Security benefits and retirement benefits. If you plan to work past the age at which mandatory distributions begin (usually 70.5 years), you can instead start taking small distributions early on to reduce your annual income in retirement. This will reduce your taxable income and place you in a lower tax bracket.
- Determine how close you are to the next marginal tax bracket to calculate the level of benefits you need to take and when. It may help to work with a financial advisor to make these calculations.
Manage tax withholding limits.Remember to consider the combined effect of tax withholding on benefits and earned income. You might have to withhold less taxes on earned income so as to not reach tax withholding limits.
Reducing Taxes by Making Withdrawals in the Right Order
Postpone Social Security payments.A retiree can start collecting Social Security benefits at any age between 62 and 70. However, starting later means that the checks are larger. From a tax perspective, only 50 percent of your Social Security benefits count towards your income. This means that waiting to collect benefits until later could maximize your income while reducing your tax burden.
Take tax-free income first.You have several options for tax-free income in retirement. The first is municipal bonds from your own state. Interests from these bonds is typically not taxable at any level (local, state, or federal). However, capital gains or discounts on bond purchases related to these bonds may still be taxable. Losses recognized on the sale of the bond may be used to offset income or other capital gains in some cases.
- Another tax-free option is taking advantage of the cash value of a life insurance policy. These may be tax-free if the policy follows IRS rules for tax-free distributions.
Withdraw from Roth accounts.Withdrawals on Roth accounts are tax free, because after tax income is used to add to the accounts.
- You can withdraw from thecontributionsin a Roth account at any time, tax and penalty free.
- You can withdraw from theearningsafter 5 years and age 59½, tax free and penalty free. Prior to these time limits, withdrawals of earnings are still tax free, but not penalty free.
Make minimum compulsory distributions when legally required.Mandatory Required Distributions (MRDs), are amounts from your retirement accounts that have to be withdrawn after you have held them for a certain length of time or you’ve reached a certain age.
- Traditional IRAs, 401(k)s, and Roth 401(k)s all have MRDs. With traditional IRAs, the MRD begins at 70½ years. The two types of 401(k)s have the same age requirement, with the exception that for people 70½ who are still working.
- If the MRD is not taken, the amount of the MRD is taxed at 50%.
Take taxable investment income as needed.Taxable accounts include mutual funds, brokerage accounts, and any money realized from capital gains.Taking from these accounts late allows you to take advantage of the benefits of long term capital gains on your investments. Remember to keep assets as long as they are appreciating in value. Let profits run while cutting losses short.
- You want to draw from these accounts first because the longer you live, the more you tap into your retirement savings, which diminishes them. At the end of life, you don’t want to see the money you use to live on taken by taxes.
- These are called taxable because you invest in the account initially with post-tax income, and you pay whenever you receive the return on the investment. So if a credit union pays yearly dividends on a savings account, you have to pay taxes on those dividends each year.
- Collectibles are taxed at a higher rate than other capital gains—as high as 28%--but that is still lower than the tax on earned income.
- The distributions from 401(k)s and IRAs are taxed at ordinary income tax rates. Therefore, you can liquidate all or a portion of an account like a 401(k) or an IRA at the beginning of retirement, make a capital investment with the money, and then sell it off after a year. Even if you take a loss on the investment, the loss might be less than the difference in tax liability.
- Capital gains taxes are progressively bracketed like regular income taxes, just at lower rates. Charles Schwab provides a full table.
Defer payment from traditional retirement accounts.Traditional retirement accounts are taxed at withdrawal and include traditional IRAs and 401(k)s. IRA stands for Individual Retirement Account and a 401(k) is a retirement sponsored by your employer. These two account types are among the oldest and most popular types of retirement accounts to invest in. However, traditional accounts have few advantages for a retiree unless he or she has considerable taxable income. Since taxes are typically lower for a retiree with less income, a Roth account is almost always preferable to traditional accounts.
- You must retire, die, or turn 59 ½ in order to withdraw without penalty from a 401(k). There are hardship exemptions with some plans, and you can see a list of common ones at
Minimizing Taxes by Other Strategies
Seek professional advice.A lot of tax issues are complex, so an accountant can help. Remember though, many people use an accountant already, and nonetheless fail to take advantage of every break available. You need to do your own research.Ask a prospective accountant the following:
- If they are a licensed CPA. The CPA designation denotes a level of education and expertise that you can't guarantee otherwise.
- How long their firm has been in existence.
- What other certifications are held by CPAs in the office. This can give you an idea of their focus. The Personal Financial Specialist (PFS) and Certified Financial Planner (CFP) designations can indicate particularly helpful specializations for reducing taxes in retirement.
- Whether you can contact any of their clients for a referral. A reputable firm should have no problem with this.
- Many retirees don’t itemize deductions, leaving billions to the IRS every year. Deductions are available for medical expenses and charitable contributions in particular. Make sure you’ve discussed possible itemized deductions with your financial planner at length.
Manage asset holding periods.The tax rates for short term capital gains are the same as they are for earned income, like wages and salaries. Hold onto assets for longer than a year to save big. The tax rates on long term capital gains are no more than 20% (but usually not more than 15%), which is less than income taxes, so selling off assets is a great way to lessen tax liability.
- For the gain to count as a long term capital gain, you have to have held the asset for a year or more.
- You can also bundle your losses to minimize liability. This is known as loss harvesting, and it is a simple if overlooked way to minimize your tax bill.
- Your capital gains and losses can either be short or long term. You are entitled to use the net figure from all of these categories to arrive at one single figure.
- So add up your long term gains (LTG) and losses (LTL). If your LTG is 10k and your LTL is 5k, that’s a net LTG of 5k.
- Then add up short term gains (STG) and short term losses (STL). STG of 6k plus an STL of 7k is a STL of 1k.
- Then add the net LTG and the net STL to get 4k in taxable LTG.
Refinance your mortgage.Another option to reduce your taxable burden is to put more of your income towards paying down your home. You can refinance your mortgage on your current home to a shorter loan term. This will increase your payments and your deductible interest, as interest paid on home loans is deductible from your tax burden. Borrowed funds are not taxable.
Consider a reverse mortgage.Reverse mortgages are a type of home equity conversion loan that is marketed toward senior citizens.The borrower gets a loan for the value of the equity in the home. Interest on reverse mortgages is not deductible, but any money advanced on equity is non-taxable.The loan can be structured in three ways:
- The loan can be structured as a line of credit.The borrower can access the line of credit at any time for whatever reason, although there may be limits on how much can be accessed in a time period. The unused balance of the line of credit actually grows in value as the home increases in value.
- The loan can be structured as a monthly payment for a fixed number of years, known as a term payment plan.The buyer receives the same amount of money each month even if the value of the home decreases.
- The loan can be structured under a tenured payment plan, which means that the buyer gets a monthly payment for as long as they remain in the home, even if the amount of payments exceed the loan value.
- Even if payments under the reverse mortgage stop, the homeowner cannot be evicted from the home.
- When the homeowner dies, the title to the house can pass onto their heirs, but the heirs have to satisfy the amount of the loan or forfeit the deed. For this reason, reverse mortgages should usually be a last resort.
Minimize liability with charitable contributions.Most people know that charitable contributions are tax-deductible. However, if you donate assets to charities wisely, you can really minimize your tax bill.
- For example, if you want to donate 0 to a charity, instead of donating it in cash, you can donate 0 worth of stock that has appreciated in value while you’ve held it. That way you can claim the deduction and avoid paying the capital gains tax on the stock.
- The reverse goes if you’ve lost money on a group of stocks. Sell first, then donate the cash. That way you can use a capital loss to your advantage and deduct the contribution from your income for the year.
Give income-producing assets away.You can reduce your own taxes by simply reducing the value of your total assets. One way to do so is to give appreciated or income-producing assets to your family members. Giving away appreciated assets can result in a tax benefit for you, whereas giving income-producing assets to family members reduces your annual income and taxes. Your family member will still have to pay taxes on the earnings or capital gains from the asset, though.
Establish a family trust.Trusts can be used to separate your estate from your spouse for inheritance purposes, which can help you avoid exemption limits for estate transfers. If, for example, you and your spouse each hold assets equal to million, and the exemption limit in your state is million, the transfer of your combined million to your heirs upon your death would be subject to additional taxes. However, if you created a trust for estate, this separate your money and your spouse's, allowing you to avoid the exemption limit.
QuestionCan I have my taxes reduced because I am on a fixed income and cannot afford them?wikiHow ContributorCommunity AnswerIt really depends, as different types of income are taxed at different rates. The IRS and other taxing authorities do not tailor their tax rates for the convenience of individual taxpayers and do not recognize "hardship" cases. Current tax rates are designed to "go easy" on people with low or fixed incomes. If you're really struggling, you may need to seek assistance from any of various low-income relief programs related to rent and utilities, for example.Thanks!
Video: Reducing Taxes in Retirement | S. 1 Ep. 21
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