You may leave behind a lot of things when you retire, but your tax burden isn’t one of them. In fact, without proper income tax reduction strategies, they can potentially be an even bigger burden in retirement. As tax specialists, we know the keys to avoiding that risk are awareness and planning.
Tax Planning Services for Your Retirement
It’s important to understand how different sources of retirement income are taxed. If your only source of retirement income is Social Security, you probably won’t pay any taxes. That’s because Social Security income – by itself – is tax-exempt. Unfortunately, if you’re like most people, Social Security won’t be enough. You’ll need other sources of income, which means a portion of your Social Security income probably will be taxed. As for how much, it varies, but it can run as high as 85%. Source: https://www.ssa.gov/benefits/retirement/planner/taxes.html
For example, you’ll probably pay that 85% if you get large monthly income payments from a pension. With the pension itself, most are funded with pre-tax income. If that’s the case, it means all your pension income is taxable each year. However, if a portion of your pension was funded with after-tax dollars, then only a portion of the income will be taxed.
For investment income from interest, dividends, or capital gains, naturally, you’ll have to continue paying taxes on that just like you did before you retired. If you have a strategy that involves systematically selling investment shares to generate retirement income, in that case, each sale will also generate a long- or short-term capital gain or loss, which you would need to report on your tax return. In most cases, and for many reasons, this is a bad strategy.
Required Minimum Distributions
The main source of retirement income for most people, besides Social Security, is the money they have in their 401(k)s and IRAs. These accounts are tax-deferred until you start taking withdrawals, which the IRS forces you to do starting at age 73 to satisfy your required minimum distributions, or RMDs. Source: https://www.bankrate.com/retirement/ira-rmd-table/
Your RMDs are unavoidable even if you have plenty of income from other sources. Through our retirement tax planning services, we can help you implement tax saving and reduction strategies that can help minimize the amount of taxes you pay when the time comes to start taking your RMDs.
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Common Questions About Tax Minimization in Retirement
Taxes can play a significant role in retirement income and long-term financial planning because different income sources are taxed in different ways. Withdrawals from traditional retirement accounts such as IRAs and 401(k)s are generally taxed as ordinary income, while withdrawals from Roth IRAs can be tax-free as long as certain conditions are met. Social Security benefits may also become partially taxable depending on your total income.
Because of these differences, the order in which income is taken from various sources can have a meaningful impact on how much you keep after taxes. By coordinating withdrawals and income sources thoughtfully, it is often possible to reduce unnecessary tax exposure and help ensure that more of your retirement income remains available to support your long-term financial goals.
Several strategies can be used to help minimize taxes in retirement, and the appropriate approach depends on each person's financial situation and income needs. In some cases, Roth conversions may be considered to move assets from tax-deferred retirement accounts, such as IRAs or 401(k)s, into Roth accounts so that future withdrawals can potentially be tax-free.
Another strategy may involve taking withdrawals from retirement accounts up to the limits of a favorable tax bracket each year so that income is recognized at lower tax rates. Any additional income needs beyond those tax brackets can sometimes be met from investments held outside of retirement accounts, which may be taxed differently. By coordinating these strategies carefully, it is often possible to manage taxable income more efficiently over time and reduce unnecessary tax exposure throughout retirement.
Tax strategies often differ before and after retirement because both income sources and tax exposures change. Before retirement, the focus is often on reducing current taxable income while working, frequently through contributions to retirement accounts such as 401(k)s or IRAs. During working years, individuals are also paying certain taxes tied to employment—such as Social Security payroll taxes, Medicare taxes, and sometimes state disability taxes—which generally go away once earned income stops.
After retirement, the focus shifts from saving to managing how and when income is taken from different sources, such as retirement accounts, investment accounts, and Social Security, in order to manage tax brackets and avoid unnecessary taxes so more of your retirement income can be preserved.