How to Manage Taxes in Retirement

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As you plan for the expenses you will have in retirement, don’t forget about taxes. They don’t go away just because you’re retired.

As at any stage of life, whether you owe federal income taxes depends on how much overall taxable income you have. In retirement, some of that income will include the money you withdraw from your 401(k), IRA or other retirement plans. Deferring income taxes on those contributions allowed you to build up your nest egg⁠—earning returns on 100% of your savings⁠—for all of the years leading up to your retirement. Once you start taking money out of those plans, however, those deferred taxes come due.

In theory (and usually in practice) this is a good trade-off because you were probably paying a higher income tax rate when you originally made that money than you will be in retirement. For example, if you put $7,000 in an IRA while you’re in the 25% tax bracket you deferred $1,750 in taxes. If you later take the money out when you’re in the 15% bracket, the taxes on that $7,000 would be $1,050 – a savings of $700.

Diversifying your retirement income

We usually think of diversification in terms of managing risk on a variety of investments. Once you’re in retirement and are drawing on these savings, diversification can also help you manage your taxable income and tax bracket. 

Although most retirement income sources such as your 401(k) are taxed as regular income, other sources may be post-tax savings vehicles such as a Roth IRA, or they may be sources such as qualified dividends that are taxed as long-term capital gains instead of adding to your taxable income. Work with your financial advisor on a withdrawal plan that takes into account all of your potential sources of retirement income.

Benefits of the 15% tax bracket

A retired couple filing jointly could have $100,000 in regular income and, after taking the $24,000 standard deduction, still fall within the 15% tax bracket. An added benefit of staying in this bracket is a 0% tax rate on long-term capital gains. So, while holding their taxable income to the desired level, the couple might still draw funds from dividends and other qualified income sources that are counted as long-term capital gains instead of regular income.

Incorporating a Roth IRA

While you’re still employed and making contributions to your retirement funds, consider working with your financial advisor to incorporate a Roth IRA into the mix. Roth accounts are one of the few retirement funds that can be drawn on during retirement without adding to your taxable income because they were not funded with pre-tax dollars. Although Roth IRAs are intended for savers below a certain income threshold, those with higher incomes can still convert a traditional IRA to a Roth. Yes, you still must pay the income taxes on the IRA amount the year that you make the conversion but doing so sets you up in the future to be able to make tax-free withdrawals from at least one of your retirement income sources.

Delaying withdrawals if you’re still in a higher bracket

Although you can start taking money out of retirement savings at 59½ and claim Social Security as early as 62, it could be best to delay both of those if you are still working and don’t need the money yet. Not only will those resources continue to grow, but you will not be paying a needlessly higher income tax rate on them. Your options diminish after age 70 for two key reasons: You’re required to start taking disbursements from your retirement accounts, and there is no longer a benefit to delaying taking your Social Security benefit.

Getting ahead of the RMD calendar

Federal law requires you take your first Required Minimum Disbursement (RMD) by April of the year after you turn 70½, but subsequent disbursements have to take place by December of each year. If you wait too long to take your first disbursement, you may have to take two in one year and pay a higher tax rate on some of it. The dollar amount of an RMD is based on the total amount of money you have in the account divided by an average remaining lifespan factor according to  IRS life expectancy tables. See IRS Publication 590-B for more on how this is calculated.

Managing non-retirement investments

If you have other investments not involving your pre-tax savings, you may have additional options to keep your taxable income at the desired level.

Harvesting” capital gains and losses is an example. Choosing when to claim a gain or loss – and whether you do so as short-term or long-term⁠—can enable you to keep your taxable income in the sweet spot just below a bracket maximum. The tax code permits you to deduct a portion of capital losses in the current tax year and defer claiming the rest until subsequent years.

Similarly, if you invest your non-retirement money in tax-managed funds, you have more control over when you have to claim the gains from those investments.

Managing your income from work

If you’re working for pay during retirement, consult with your tax advisor to estimate your taxable income during the year so you can moderate the amount you work to stay in your desired bracket.

Estimating taxes on your Social Security check

Depending on your level of income from other sources, up to 85% of your annual Social Security benefit may count as taxable income – possibly pushing you into a higher bracket.

Making charitable contributions from your IRA

After age 70½, you’re required to take a minimum distribution from your IRA, and sometimes this can push your taxable income into a higher marginal bracket. If you direct an IRA withdrawal into a qualified charity, you do not have to claim that required withdrawal as income.

Don’t forget other taxes

So far, we’ve only discussed federal income taxes. You also need to plan for how your state will tax your income in retirement, and even if you have no mortgage when you retire, you will still have to pay property taxes. Work with your financial advisor to ensure that all of those costs are covered by your retirement plan.

Meet with a financial advisor today to learn more about managing your taxes in retirement.