If you’re nearing retirement age, it’s essential to consider ways to minimize your tax liability to make the most of your retirement funds. Paying higher taxes during retirement means having less money to enjoy your golden years. There are several strategies to reduce the amount of taxes you pay, including withdrawing money from retirement accounts, understanding your tax bracket, making withdrawals earlier than necessary, investing in tax-free bonds, and making long-term investment decisions. Additionally, moving to a tax-friendly state can also help lower your tax burden. By implementing these smart strategies, you can effectively minimize your tax liability and have more financial freedom during retirement.
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Remember to Withdraw Your Money From Your Retirement Accounts
Retirees must remember to start withdrawing money from their traditional 401(k)s and IRAs by the time they reach 73 years old. These mandatory withdrawals are known as required minimum distributions (RMDs) and were previously effective at age 72. However, under the SECURE Act 2.0, signed by President Biden in late 2022, the RMD age increased by one year for those turning 73 in 2023.
RMDs must be taken by April 1 of the year following the calendar year in which the retiree turns 73. It’s important to note that if a retiree is still working after age 73 and does not own more than 5% of the company they work for, they are allowed to delay withdrawing from their 401(k) until retirement. However, this exception does not apply to IRAs. Starting in 2033, RMDs will begin at age 75.
Failing to withdraw the minimum distribution by the deadline will result in a 25% penalty on the amount that should have been withdrawn, in addition to paying the income tax due on the withdrawal. Therefore, withdrawing money from retirement accounts in a timely manner is an easy way to reduce tax liability in retirement.
Understand Your Tax Bracket
Retirees need to understand their tax bracket to effectively manage their tax liability. One important consideration is that Social Security benefits may be taxable if one-half of the retiree’s benefits plus all of their other income, including tax-exempt interest, exceeds the base amount for their filing status. The base amount is determined by the IRS based on filing status:
- $25,000 for single individuals, heads of households, and qualifying surviving spouses
- $25,000 for those married filing separately and living apart from their spouse for the entire year
- $32,000 for those married filing jointly
- $0 for those married filing separately and living with their spouse at any time during the tax year
Reporting higher income to the IRS will push retirees into higher tax brackets. This is important to consider when making withdrawals from taxable accounts like IRAs, 401(k)s, or pensions. If a retiree is on the edge of a tax bracket, they may want to withdraw slightly less from their taxable accounts to remain in a lower tax bracket and reduce their overall tax bill. Withdrawals from a Roth IRA account, on the other hand, are tax-free.
Make Withdrawals Before You Need To
Taking smaller distributions from retirement accounts during one’s 60s can be a smart strategy. This approach helps spread out tax liability over more years, keeping retirees in a lower tax bracket and reducing their tax bill over their lifetime. Ideally, retirees should make these withdrawals during a year when their income is lower. For example, if a retiree has retired but has not yet started taking Social Security benefits, that would be an opportune time to make withdrawals from retirement accounts.
Invest in Tax-Free Bonds
Investing in tax-free bonds can be a smart strategy for retirees looking to reduce their tax liability. Federal bonds are generally exempt from state and local taxes, although the income from these bonds must be reported when filing federal taxes. Additionally, state or municipal bonds often do not trigger state or city taxes on the profits.
Invest for the Long-Term, Not the Short-Term
Retirees should consider investing for the long-term rather than the short-term. When selling an asset, such as a stock or mutual fund, the retiree will owe a capital gains tax on the profit. The tax rate for capital gains depends on how long the asset was owned. If the asset was held for more than a year, it will be taxed at the more favorable long-term capital gains tax rate. However, if the asset is sold within a year of purchasing it, the sale is considered a short-term capital gain and gets taxed as ordinary income.
Short-term capital gains can be taxed as high as 37% in 2023, depending on the retiree’s tax bracket. By holding onto assets for longer than a year, retirees can be subject to lower tax rates of 0%, 15%, or 20%, depending on their income level.
Move to a Tax-Friendly State
Some states are more tax-friendly for retirees than others, making them attractive options for relocation. For example, Alaska, Montana, Oregon, New Hampshire, and Delaware do not have sales tax. Additionally, there are nine states that do not collect personal income tax: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. However, it’s important to consider the cost of moving and the impact on family visits when deciding to relocate for tax reasons.
Philanthropic Retiree Tax Strategies
Retirees who engage in philanthropy may consider utilizing qualified charitable distributions (QCDs) from their IRAs. QCDs are payments sent directly from the IRA to qualified charities. These payments satisfy the retiree’s RMD requirement and do not count as taxable income, effectively reducing their tax liability. Another strategy is harvesting losses in the investment portfolio to offset capital gains and lower the capital gains tax.
Consult a Financial Advisor
Working with a financial advisor is crucial for retirees seeking to optimize their tax strategy. A financial advisor can provide valuable guidance and assistance with managing investments and maximizing tax efficiency. They can help retirees navigate the complexities of the tax code, identify tax-saving opportunities, and develop a personalized retirement plan. Consulting a financial advisor can help retirees make informed decisions and ensure they are taking full advantage of the available tax benefits.