Minimizing your tax bill in retirement

Many people are concerned about taxes taking a bite out of their retirement income. With a little planning, your taxes in retirement will likely be lower than during your working years. Here are some suggestions for keeping your retirement tax bill to a minimum.

First, your taxes in retirement may be lower than you think. A common mistake is to overestimate the amount of taxes you’ll have to pay after retirement. You should look at your expected income sources in retirement and how each will be taxed. While you’re working, your salary is taxable at ordinary income tax rates.

But, even if your income puts you in a high tax bracket, not all of your income is taxed at that rate. For example, if you’re single and your income is $100,000, you’re in the 28% tax bracket. According to this site, however, in 2015 only the part of your income above $90,750 is taxed at 28%; the rest is taxed at lower rates, making your effective tax rate 21.07%.

After retirement, this will also be true of your pensions, distributions from taxable retirement accounts, and any rental and business income. Even though those are taxable, being in the 28% tax bracket doesn’t mean a full 28% of your retirement income will go to taxes. Furthermore, the bulk of Roth IRA and 401(k) distributions are not taxable; dividends and capital gains, master limited partnerships, and Social Security are taxed at lower rates depending on your situation.

So your tax bill will likely not be as high as you think at first. There are also some ways to reduce it:

Minimize your expenses.

This will lower the amount you’ll have to withdraw from tax-deferred retirement funds. Keeping your expenses low will enable you to stay in the lowest tax bracket and take advantage of tax breaks. This site helps you estimate your tax bill.

One major expense is your home mortgage. Many financial advisors recommend paying off your mortgage before retirement. Not only will this eliminate a sizeable monthly check you have to write, but it will reduce the amounts you’ll have to take out of your retirement funds.

Manage your investments.

Qualified dividend income and long-term capital gains can be taxed at very different rates depending on your tax bracket. This is another good reason to stay in the lowest bracket, where the tax rates on these investments are zero.

Roth IRA and Roth 401(k) funds are not taxed if the distributions are qualified. In general, distributions are qualified if you are at least age 59 ½ and have held the funds for at least five years. Check the appropriate IRS document for more information.

Diversify your investments.

You may have retirement income from Social Security, pensions, taxable accounts, tax-deferred accounts, tax-free accounts (e.g. Roth IRAs), savings accounts, rental property, and more. There are times when it’s handy to be able to manage your income to lower your tax bill. For example, if you anticipate a large return from your other investments one year, you might consider taking income from your tax-free accounts that year to minimize your tax bite.

Master Limited Partnerships may be a good way to lower your taxes because the income from MLPs is return of capital, which is not taxable. Real Estate Investment Trusts (REITs) potentially offer income as well as tax savings. Dividends from REITs are taxed as ordinary income; dividends in excess of the REIT’s taxable income are treated as a return of capital. As with MLPs, the return of capital reduces the investor’s cost basis.

Annuities and many life insurance policies also provide tax-free income. You have to be remember, though, that taking income from a life insurance policy may reduce the value of the policy.


Finally, you might consider moving to a more tax-friendly state. Although moving is expensive and seemingly drastic, you might find your savings will make it worth it to move. Some states have lower state income tax rates, as well as living expenses. This site can help you find such states and estimate how much you might save by moving.

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