Taxes will play a significant role in how much money you have available to spend in retirement. During your working years, you may have used specific strategies to manage your tax liability or defer taxes. These strategies should change with your income level over time. By reevaluating your finances at retirement age, you may find ways to minimize the taxes you’ll owe during the next decades.
As you think about taxes in retirement, consider the following strategies:
1. Carry out a Roth conversion.
2. Delay Social Security benefits.
3. Plan for required minimum distributions.
4. Evaluate states with low taxes.
5. Create a trust.
1. Carry Out a Roth Conversion
Unlike tax-deferred retirement accounts, Roth IRAs and Roth 401(k)s allow you to contribute after-tax dollars. This means that the withdrawals you take in retirement will be tax-free, as long as you meet the criteria listed.
You can take contributions tax-free at any time. However, you must be 59 1/2 and the account must be open for at least five years before withdrawing earnings without taxes and penalties.
You might choose to convert a 401(k) or IRA to a Roth, though you’ll want to plan carefully. “This approach requires meticulous management to prevent clients from moving into higher tax brackets, ultimately defeating the purpose of reducing taxes on distributions,” said William F. Davis, a certified financial planner and managing partner with Vericrest Private Wealth in Newtown, Pennsylvania, in an email. You may want to convert pre-tax accounts into a Roth during a year when your income is lower. The amount you convert will be subject to income taxes, and then the earnings on the converted amount will grow tax-free.
[Read: How to Reduce Your Lifetime Tax Bill With a Roth IRA.]
2. Delay Social Security Benefits
Once you start taking Social Security benefits, the amount you receive could be subject to taxes, depending on your income level. If you file taxes as an individual and have a combined income that exceeds $25,000, you’ll pay taxes on up to 85% of your Social Security benefit. For married couples with a combined income of more than $32,000, up to 85% of the Social Security benefit will also be taxed. Your combined income consists of your adjusted gross income, tax-exempt interest income and half of your Social Security benefits.
If possible, consider using other income sources to support yourself during your early retirement years and then apply for Social Security benefits later. You’ll be eligible for your full benefit once you reach full retirement age, which is 66 or 67 for most people. The benefit amount will increase by 8% annually until you turn 70.
You might look at delaying claiming Social Security until you reach age 70. “This gives retirees an opportunity to utilize pre-tax accounts at lower income tax rates, while also giving themselves an equity-like return of 8% per year that they choose to delay claiming from their full retirement age until age 70,” said Kevin McLoughlin, a certified financial planner and co-founder of Trio Wealth Management in McLean, Virginia, in an email.
3. Plan for Required Minimum Distributions
Once you turn 73, you’ll generally be required to begin taking RMDs. These are annual withdrawals from traditional IRAs and 401(k)s. You could face a penalty if you don’t take your scheduled RMD. However, RMDs can also create a tax burden, as the amount you take will be subject to income taxes for that year.
“Carefully planning withdrawals to stay within lower tax brackets can significantly reduce taxes owed,” said David Brillant, a certified specialist in estate planning, trust and probate law, and a tax attorney at Brillant Law Firm in Walnut Creek, California, in an email.
4. Evaluate States With Low Taxes
“Understanding and leveraging state tax laws can also result in significant savings, as some states offer favorable tax treatments for retirees, including exemptions on Social Security benefits and pensions,” Brillant said.
Start by looking at the taxes in your area, including income taxes, sales tax and property tax. You won’t pay state income tax if you live in Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington or Wyoming. However, be sure to look at the overall picture, as some states might not tax Social Security benefits but have higher taxes in other areas.
[READ: The Most Tax-Friendly States for Retirees]
5. Create a Trust
“By placing assets in certain types of trusts, such as an irrevocable trust, you can effectively remove those assets from your taxable estate,” said Marty Burbank, an elder law attorney at OC Elder Law in Fullerton, California, in an email.
An irrevocable trust moves assets from your control and name to your beneficiaries. You’ll appoint a trustee responsible for managing the trust and administering its assets according to the terms listed. As its name implies, an irrevocable trust typically means that once you establish the terms, you’ll be unable to change them. You might place assets such as investments, cash or life insurance policies in a trust.
“This not only protects them from estate taxes but can also offer income tax advantages, as the income generated by assets in the trust may be taxed at a different rate or potentially not attributed directly to you,” Burbank said. Due to the complexity of a trust, you’ll want to work with a professional to set it up the way you want.
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5 Ways to Minimize Taxes on Retirement Income originally appeared on usnews.com
Update 03/14/24: This story was published at an earlier date and has been updated with new information.
