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Retirement planning can be complicated. But ignoring the tax consequences of your retirement income can take a bite out of your nest egg. Luckily, you can take a few strategic steps to minimize your tax liability. Here are five common strategies to consider. And, if you prefer a more hands-on approach, a financial advisor can help you create a personalized retirement plan.
As you plan for retirement, you should understand how your Social Security benefits may be taxed. If you have additional retirement income, such as from a 401(k) or part-time employment, you should anticipate owing some taxes on your Social Security benefits. However, if Social Security is your sole income source, you’re less likely to owe taxes on these benefits.
For 2024, individual retirees with a combined income between $25,000 and $34,000 could get taxed on a maximum of 50% of their benefits. While those over $34,000, could get taxed on a maximum of 85% of benefits.
For retired couples, the thresholds are between $32,000 to $44,000 for 50% taxation, and over $44,000 for 85% taxation.
Finally, you should note, however, that some states exempt Social Security benefits from state income tax.
Your investment portfolio can increase your tax liability in retirement through capital gains taxes, taxable dividends, interest income, and required minimum distributions (RMDs) from tax-deferred retirement accounts, all of which may push you into higher tax brackets and impact the taxation of your Social Security benefits.
To minimize tax liability from your investment portfolio in retirement, consider tax-efficient investment strategies such as holding investments long-term to qualify for lower capital gains rates, consider converting your retirement savings into tax-advantaged accounts like Roth IRAs, optimize asset location to place tax-inefficient investments, which can reduce the amount of taxable income generated each year in tax-deferred accounts, harvest tax losses to offset gains, and be strategic about when to take withdrawals to manage taxable income levels.
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Required Minimum Distributions (RMDs) are the annual withdrawals that the U.S. federal government mandates individuals to make from tax-deferred retirement accounts once they turn age 73. And these could potentially increase your taxable income by pushing you into a higher tax bracket.
You can mitigate your tax liability from RMDs by considering strategies such as donating directly to charity through qualified charitable distributions (QCDs), using the “still-working” exception if applicable, converting traditional IRA assets to Roth IRA assets, or strategically managing other sources of income to stay within lower tax brackets.
Take note: Failing to comply with RMD rules can result in a hefty penalty — up to 50% of the required distribution that was not taken.
A deferred annuity can help lower your tax liability in retirement by allowing you to invest funds on a tax-deferred basis. This means that you don’t have to pay taxes on any investment gains until you start receiving distributions. So, for example, you can time your withdrawals strategically to coincide with lower tax brackets later in retirement.
One thing to keep in mind: If you can buy an annuity within your IRA or 401(k), you can use pre-tax dollars to fund the annuity and effectively reduce your taxable income for your contribution year.
Furthermore, instead of taking large lump-sum withdrawals from the annuity, consider taking partial withdrawals over time to manage your taxable income more effectively and potentially stay within lower tax brackets.
Finally, take a look at different types of deferred annuities, such as fixed or variable annuities, as they could offer different tax advantages and features that are suited to your specific retirement goals and tax situation.
Tax-advantaged accounts like traditional IRAs, Roth IRAs, 401(k)s, and health savings accounts (HSAs), offer many tax benefits to build a substantial retirement nest egg over time. These benefits can include:
Developing an effective tax strategy for your retirement can help you maximize savings, minimize current tax liabilities and plan for future goals strategically. Being aware of Social Security taxes, optimizing your investment portfolio, planning your RMD withdrawals, investing in a deferred annuity and using tax-advantaged accounts before retirement can position you on a path toward a sustainable retirement.
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