Transitioning to retirement requires plenty of careful planning. But did you know that retirement brings a new set of tax considerations and challenges?
In your working years, you might have been a W-2 employee, which meant your taxes were automatically withheld from your paycheck. Unless you earned additional income from dividends, rental income, or contract work, you may not have had to make estimated payments or set aside some of your savings to cover additional tax obligations.
But in retirement, you’ll need a tax strategy that accounts for your various income sources – especially since tax treatment will vary across the board. Here are seven top tax planning tips for retirees to consider.
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1. Understand Retirement Income Sources
Before you can start to build a tax strategy, you should first identify where your income will come from in retirement. You and your financial advisor can work together to develop a withdrawal strategy that pulls from different sources of income throughout your retirement. This strategy is often dependent on the tax treatment of withdrawals and earnings.
Common income sources include:
Traditional 401(k) and IRA
Because these are funded with pre-tax dollars, anything you withdraw from your 401(k) or IRA will be treated as taxable income in retirement.
Social Security
If you earn taxable income besides Social Security, you may be responsible for paying federal taxes on up to 85% of your Social Security benefits. This will be based on what the IRS determines is your “combined income.”
Combined income is your Adjusted Gross Income (AGI) + Non-taxable Interest + ½ of your Social Security benefits.
If you’re an individual tax filer and your combined income is between $25,000 and $34,000 (or $32,000 to $44,000 for joint filers), you may need to pay taxes on up to 50% of your Social Security benefits. If your combined income is more than $34,000 (or $44,000 for joint filers), you may need to pay taxes on up to 85% of your benefits.
Be aware that some states will tax Social Security benefits at the state level as well.
Pensions and Annuities
Similar to a 401(k), if your pension plan or annuity is funded with pre-tax dollars, your payments will be subject to income tax in retirement. However, most pension plans and annuities are subject to federal tax withholding requirements, meaning your provider will likely hold on to some money to help cover your tax obligation. If you’re unsure about the status of your pension or annuity payments, the IRS offers this tool for determining your tax obligation.
Roth IRA
A Roth account is funded using after-tax dollars. It doesn’t lower your tax obligation for the year the contributions are made (as contributions to a traditional IRA or 401(k) would). Still, they do offer steep tax advantages in retirement. Retirees can enjoy tax-free withdrawals of the principal amount in their Roth IRA. If they are over 59 ½ and have held on to the account for at least five years, they can take tax-free qualified distributions as well.
2. Stay Informed About Tax Law Changes
In 2017, the Tax Cuts and Jobs Act (TCJA) changed major tax laws. The ruling included changes such as:
- Lowering most individual income tax rates and the corporate income tax (CIT) rate
- Increasing the standard deduction
- Limiting certain popular itemized deductions (such as charitable contributions and mortgage interest)
- Increasing the federal estate tax exemption limit
Though some provisions outlined in the original TCJA have been made permanent, the ruling is set to sunset (or expire) at the end of 2025. It’s possible that over the next two years, there will be changes to federal tax laws in preparation of that date.
It’s possible that your state and local tax laws can change at any time as well. For this reason, it’s helpful to work with a tax advisor who’s aware of tax law changes and can stay on top of the latest updates.
3. Maximize Retirement Account Contributions
Still growing your savings? If you’re over 50, you can make catch-up contributions to your retirement savings accounts. In 2023, for example, you can save an additional $7,500 to your 401(k) or an extra $1,000 to your IRA.2
Minimizing Taxes on 401(k) and Roth Withdrawals
Maximizing your savings is important, but so is minimizing how much of your withdrawals will go to taxes in retirement. One way to reduce your tax obligation in retirement is to do a Roth IRA conversion ahead of time.
This requires transferring the funds in your 401(k) or traditional IRA into a Roth IRA account. As a result, the money you withdraw in retirement will be tax-free. The kicker is you must pay taxes on the amount you converted in the year the conversion is made.
If this is a strategy you’re considering, it may help to time your Roth conversion for a year in which you believe your other taxable income sources will be lower. This could be the year you retire, for example. Remember that to benefit from tax-free qualified distributions, you’ll need to hang on to the Roth IRA for at least five years.
If you plan on using those funds before the five-year mark, it may not be worth pursuing a conversion. Talk to your advisor and tax professional about your unique circumstances and whether this strategy may be right for you and your retirement income needs.
4. Utilize Tax-Efficient Investment Strategies
Your investments will likely play an integral role in your retirement income strategy. But how, exactly, are your investments taxed? If you earn interest on investments in a taxable brokerage account, that interest will be taxed at your ordinary income tax rate.
However, other income earned from a taxable investment account, including qualifying dividends and capital gains, are taxed at either a long-term or short-term capital gains rate. Investments held for longer than one year are taxed at the long-term rate, while those held for less than a year are taxed at the short-term rate.
Depending on your tax bracket, the long-term capital gains rate will fall between 0% and 20%. Short-term capital gains tax is the same as your ordinary income tax rate, which can go up to 37% in 2023.
Taxable accounts are attractive income sources for retirees because of their favorable capital gains rate (on long-term gains) and their flexibility. Retirees won’t be subject to a tax penalty for withdrawing before age 59 ½ (as is the case for 401(k)s or IRAs).
Depending on your investment performance, you may be able to claim capital losses within your taxable accounts as a way to offset capital gains. You’ll want to discuss options with your tax professional and financial advisor as these tax-minimization strategies can get complex.
5. Consider Charitable Giving
If you’d like to incorporate philanthropic planning into your retirement plans, you have plenty of tax-efficient options.
A donor-advised fund (DAF) is a common tool for reducing taxable income while setting aside funds for charity. With a DAF, you set up an account with a 501(c)(3) sponsor and make contributions. Anything you contribute to the DAF (money or assets) becomes its property. In return, you can deduct the amount you contributed from your taxes (as long as you itemize deductions). The assets can grow tax-free within the account, and you can work with the sponsor to determine which organizations ultimately receive the funds.
Charitable trusts work similarly: you contribute money to a trust, deduct a portion of the contributions from your taxable income (depending on the type of trust), and determine which organizations will receive income from it. There are a few different types of charitable trusts, which in some cases allow family members to receive payouts from the trusts.
If you’d like to incorporate charitable giving into your retirement income strategy, your advisor can help.
6. Manage Required Minimum Distributions (RMDs)
Starting at age 73, you must take required minimum distributions (RMDs) from your 401(k) and traditional IRA. Roth IRAs, however, do not have RMDs.
RMDs are important in your tax strategy since they add to your taxable income. Failure to take them in a timely manner can result in a hefty 50% tax penalty (which drops to 25% if the issue is remedied within two years).
It’s important to account for the additional tax obligation of RMDs within your retirement income strategy. If you’d like to avoid increasing your taxable income – and you don’t need the money to meet your needs in retirement – you have the option to make a qualified charitable distribution (QCD). In this case, your RMDs (or a portion of your RMDs) would go directly to a qualified charity. In return, you can deduct the amount from your income for the year the QCD is made.
7. Seek Professional Advice
A team of financial professionals can help you navigate the complex tax situations that tend to arise in retirement. By proactively planning your withdrawal strategy, you can minimize tax obligations and preserve your hard-earned retirement savings. They can even help prepare you with tax planning strategies as you near retirement to get a head start.
The Road Ahead
You’ve worked hard to put yourself in a position to retire. Maintaining awareness – and maximizing opportunities – around the ins and outs of retirement tax planning can bring you increased peace of mind. Reach out to an Abacus advisor today to learn more about how we can help you expand what is possible in retirement.
