How to Reduce Taxes in Retirement

A retired women smiles as she researches ways to reduce taxes in retirement.

Everyone can benefit from a reduction in taxes, but retirees on a fixed income need to be especially vigilant. After a lifetime spent working, the last thing you want to do is fork over more money to the Internal Revenue Service (IRS). Plus, your retirement funds will stretch a lot further with less of it going to Uncle Sam. Unfortunately, the income you receive from Social Security and investments remain taxable in retirement, but proper planning can help you reduce those taxes.

Put Money Into a Roth IRA or Roth 401(k)

Not all 401(k)s or Individual Retirement Accounts (IRA) are created equal. Traditional 401(k) and IRA contributions are tax-deductible upfront, but withdrawals are taxed in retirement. On the flipside, Roth 401(k)s and IRAs are taxed on the front end but offer tax breaks in retirement with free withdrawals. But Roth does have its perks, as it offers fewer restrictions for retirees. While traditional IRAs require you to start taking the minimum at age 72, there are no minimum distribution rules with Roth. To qualify for a Roth IRA in 2020, individuals must earn no more than $124,000 and couples must earn no more than $196,000. A mix of both could also help reduce taxes if withdrawals are balanced appropriately.

Try to Lower Expenses

Withdrawals made from traditional retirement accounts are taxable. One way to keep these tax payments down is to lower your expenses so you won’t have to withdraw as much. You can create a budget to pinpoint areas where you might want to reduce your spending. Making major life changes—such as downsizing to a smaller house or moving to a region with a lower cost of living—can also help minimize expenses. Another option is to paying off outstanding debts like mortgages to lessen the need for withdrawals from your taxable retirement accounts, as this results in a lower tax bill.

Delay Social Security Payouts

It may be beneficial to hold off on claiming Social Security for as long as possible. It’s almost a foregone conclusion that you file for Social Security as soon as retirement hits, but if you have other sources of income to draw from, delaying Social Security helps reduce taxes in retirement. Depending on your tax bracket, up to 85 percent of your Social Security income may be taxable, so holding off on filing immediately lowers your tax obligation. Also, the longer you wait to file, your benefit can grow up to 8% each year until your 70th birthday. Note that Social Security benefits are not taxable if your income is less than $25,000 and you’re single, or less than $34,000 if you’re married.

Find Out Which Types of Income are More Advantageous Tax-Wise

Certain types of income offer tax advantages. Any income from the use or occupation of a property is subject to regular taxation, but there are several deductions you can enjoy as the owner of rental real estate. Expenses from depreciation, repairs, maintenance, and insurance may all be deducted on your tax return, leaving you with no taxable rental income. Another type of income with certain advantages is capital gains. These are the profits made from selling assets like land or stocks. If the sale takes place after a year of ownership, the tax rate is much lower than your normal income tax, and if you fall within the range of $39,375 for single filers or $78,750 for married joint filers, there are no taxes on capital gains. Seniors are also eligible for tax breaks, as the standard deduction increases for single and joint filers over 65.

Consider Moving to Another State

There are several perks to relocating in retirement—a better climate, closer proximity to family and friends, or more reasonably priced housing. But you can also add fewer taxes to that list. Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming are the seven states which do not charge a general income tax, nor do they tax on retirement income, including 401(k), IRA, or Social Security. These states also do not impose inheritance or estate taxes.

New Hampshire and Tennessee only impose income taxes on dividends and interest—the former a flat 5% tax and the latter a progressively decreasing rate, which is at 1% in 2020 and should go down to 0% in 2021. Other tax-friendly states include Illinois, which charges a relatively low, flat 4.95% income tax but completely exempts 401(k), IRA, and pension income from tax. However, the 401k and pension must come from a qualified employee benefit plan to reap tax-free benefits. Social Security benefits in Illinois also escape taxation.

Mississippi currently charges 3% on taxable income of $1,000 or more and 5% on taxable income of $10,000 or more. From 2022, a new, low flat rate of 4% will be applied to taxable income between $5,001 and $10,000, but the Magnolia State does not tax Social Security or retirement income for those over 59½ years old. Pennsylvania is another state that only taxes early retirement income.

Make a Charitable Gift

Tax-free contributions from an IRA as gifts can have positive tax implications. At the age of 72, you must take your first required minimum distributions (RMD) from your IRA. This RMD is taxable income, which could catapult you into a higher tax bracket, depending on your eligibility for some standard deductions and tax breaks. Instead, you have the option to make a qualified charitable distribution (QCD). These do not count towards your adjusted gross income and lessen the chances of having more of your Social Security benefits taxed, so if you can afford a generous donation, there are advantageous tax protections.

These suggestions can help reduce taxes in retirement, which means more money left over for vacations, hobbies, and other activities in your golden years. Remember to consult a professional for proper financial planning and to start researching well ahead of retirement to ensure you’re getting the most out of your money later on in life.

The views expressed by the author are not necessarily those of Fifth Third Bank, National Association, and are solely the opinions of the author. This article is for informational purposes only. It does not constitute the rendering of legal, accounting, or other professional services by Fifth Third Bank, National Association or any of their subsidiaries or affiliates, and are provided without any warranty whatsoever. Deposit and credit products provided by Fifth Third Bank, Member FDIC.