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How to Reduce Taxes in Retirement

The good news is retirement brings solitude, a slower pace of life, and an end to the daily commute. 

The bad news is your obligation to pay taxes continues.  In fact, according to the Financial Industry Regulatory Authority, income taxes can be your single largest expense in retirement.

When planning for retirement, it’s important to understand how you will be taxed and determine how to reduce taxes in retirement.

How you are taxed

Social Security benefits 

You may have to pay taxes on the part of your Social Security income.  Calculating whether your benefit is taxable can be confusing.  

IRS Publication 915 provides guidance and a helpful worksheet to assist you in making this determination.  The taxable percentage of your Social Security benefits can range from 50 to 85%, based on your total income.  The higher your income, the higher the percentage of the benefits to be taxed.

IRAs and 401(k)s

When you take withdrawals from your 401(k) plan and traditional IRAs, you will be taxed at your marginal tax rate, assuming your contributions were made with pre-tax money.

While the tax hit is unwelcome, remember that you have been accumulating earnings in these plans on a tax-deferred basis, often for many years. 

Withdrawals from Roth IRAs are 100% tax-free, assuming you are 59½ and have held your Roth IRA for a minimum of five years.

Pension income

Taxes from pension income are computed the same as taxes from other tax-deferred accounts.  You accrue taxes at your marginal tax rate when you file your return for the year you received the distributions.

Sale of stocks and bonds

The sale of stocks and bonds in taxable accounts may trigger a capital gains tax based on the positive difference between the asset price and the original purchase price.

Capital gains taxes for assets held less than one year are taxed at your marginal tax rate.  If you held the asset for more than one year, you would be taxed at the lower, long-term capital gains tax rate, from 0 to 20%, depending on your income. 

Many states also levy a capital gains tax.  Here are the details on the tax rates imposed by those states.

Taxes on dividends

“Qualified dividends” are taxed differently and at a lower rate than “non-qualified” dividends.

Non-qualified dividends are taxed at your marginal tax rate.  Qualified dividends are taxed at the long-term capital gains tax rate.

Fortunately, most dividends paid by U.S. companies are qualified dividends. 

Some examples of non-qualified dividends are those paid by REITs and master limited partnerships and dividends paid on savings or money market accounts.  You can learn more about non-qualified dividends here

How to reduce taxes in retirement

Invest in Roth accounts

You do not have to pay taxes in retirement on the distributions from Roth IRA and Roth 401(k) plans as long as you follow IRS withdrawal rules

Investing in Roth IRAs and Roth 401(k) plans can be a very effective way to reduce taxes in retirement.

Hold for the long-term

The long-term capital gains rate is lower than the short-term rate.  When possible, hold stocks and bonds for more than a year to take advantage of the lower rate.

Avoid early withdrawals

The 401(k) withdrawals and made before 59½ years of age can result in a tax penalty of 10%. 

There are ways to avoid the early withdrawal penalty.  Under certain circumstances, paying for medical costs and health insurance, having a disability, making a first-time home purchase, and paying for qualified higher-education expenses can be exceptions to the 10% penalty rule.  There are as well. 

Catch up contributions

If you are 50 or older, you may be eligible for catch-up contributions which will permit you to invest more in your retirement plans and defer taxes on the amounts invested until you withdraw.

Time your withdrawals 

If possible, time your withdrawals from retirement accounts, so they occur in years when you are in a lower tax bracket. 

For example, if you are in your 60s, you can withdraw unlimited amounts from your retirement plan without penalty, but you have no obligation to do so.  It may be prudent to defer withdrawals to a year when your income will be lower.

Tax efficient withdrawals

Taxable accounts, traditional retirement accounts, and Roth retirement accounts are taxed differently.  The account from which you elect to take withdrawals, and the timing of those withdrawals, can have a major impact on how long your money will last.

Some experts advise making proportional withdrawals every year, based upon that account’s percentage of their total savings.  The benefit of this approach is a more predictable tax bill and possibly lower taxes and higher income over your lifetime.

Since every situation is different, you should consult with a registered investment advisor or a tax professional to determine which opportunity to reduce taxes in retirement is best suited for you.

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When planning for retirement, it’s important to understand how you will be taxed and determine how to reduce taxes in retirement.


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