How to Pay Less Taxes During Retirement

In retirement, various income sources replace a steady paycheck, each with its own tax rules. The priority shifts from accumulating assets to generating sustainable income while minimizing taxes. Unlike during your working years, you are now in control of managing your tax payments, making a tax strategy a central component of a secure retirement.

Managing Income from Retirement Accounts

Most retirement assets are tax-deferred, tax-free, or taxable. Tax-deferred accounts, like traditional IRAs and 401(k)s, are funded with pre-tax dollars, and withdrawals in retirement are taxed as ordinary income.

In contrast, tax-free accounts, such as Roth IRAs and Roth 401(k)s, are funded with after-tax dollars, making qualified withdrawals free from federal income tax. Taxable accounts include standard brokerage and savings accounts where you invest after-tax money. For these, you pay taxes annually on dividends and interest, and capital gains taxes on appreciated assets when they are sold.

Withdrawal sequencing involves choosing which account to tap each year to control your taxable income. Many retirees start by spending from taxable brokerage accounts, allowing tax-deferred and tax-free accounts to grow. Selling assets held for over a year in a taxable account results in long-term capital gains, which are taxed at lower rates than ordinary income.

The next source is tax-deferred accounts, withdrawing enough to meet spending needs without entering a higher tax bracket. Tax-free Roth accounts are preserved for last as the funds won’t increase your taxable income. This strategy must also account for Required Minimum Distributions (RMDs).

The government requires withdrawals from tax-deferred retirement accounts starting at age 73, which increases to 75 in 2033. These mandatory withdrawals are taxed as ordinary income and can increase your tax liability. RMDs force income realization and must be part of any long-term withdrawal plan.

Strategic Roth Conversions

A Roth conversion is when you transfer funds from a traditional, pre-tax retirement account to a Roth account. The converted amount is added to your taxable income for that year and taxed at your ordinary income tax rate. In exchange, future qualified withdrawals of the funds and their earnings will be tax-free.

This strategy is best if you anticipate being in a higher tax bracket later in retirement. Paying taxes on the funds during a lower-income year can reduce your lifetime tax bill. This move locks in your current tax rate on the converted funds.

A good time for Roth conversions is often between retirement and the start of Social Security benefits and RMDs. During this period, your taxable income may be at its lowest. Converting funds during these “gap years” allows you to move money to a Roth IRA while in a lower tax bracket.

Before a conversion, project your future income to estimate your future tax bracket. You must also have funds available outside your retirement accounts to pay the income tax on the conversion. Using money from the conversion to pay the tax reduces the amount moved into the Roth account and diminishes its growth potential.

Optimizing Social Security and Investment Income

The IRS uses “provisional income” to determine how much of your Social Security benefits are taxable. This is calculated by taking your modified adjusted gross income (MAGI), adding tax-exempt interest, and then adding 50% of your Social Security benefits.

For married couples filing jointly, if your provisional income is between $32,000 and $44,000, up to 50% of your benefits may be taxable; if it exceeds $44,000, up to 85% may be taxable. For single filers, the 50% threshold starts at $25,000, and the 85% threshold begins at $34,000. Managing other income sources can help keep your provisional income below these thresholds.

Tax-loss harvesting is selling investments at a loss to offset capital gains. If your losses exceed your gains, you can use up to $3,000 of the excess loss to offset ordinary income each year. Any remaining losses can be carried forward to future years.

When implementing tax-loss harvesting, you must be aware of the “wash-sale” rule. This IRS regulation prevents you from claiming a loss on a security if you buy a “substantially identical” security within 30 days before or after the sale. This rule requires careful timing to ensure the realized loss is deductible.

Leveraging Charitable and Health Related Deductions

A Qualified Charitable Distribution (QCD) allows individuals aged 70½ and older to direct up to $108,000 annually from their traditional IRA to a qualified charity. This can satisfy all or part of an annual RMD. The distributed amount is excluded from your adjusted gross income (AGI).

Lowering your AGI with a QCD can reduce the taxable portion of your Social Security benefits and help avoid Medicare premium surcharges. This allows you to support charities while managing your tax liability.

A Health Savings Account (HSA) offers a triple-tax advantage: contributions are tax-deductible, funds grow tax-free, and withdrawals are tax-free for qualified medical expenses. While you cannot contribute to an HSA once enrolled in Medicare, the account balance can be carried over indefinitely.

In retirement, you can use accumulated HSA funds to pay for medical costs, including Medicare premiums, deductibles, and long-term care insurance premiums. Using these tax-free funds for healthcare reduces the need to make taxable withdrawals from other retirement accounts to cover these expenses.

State Tax Planning Considerations

State tax laws vary significantly and affect your retirement tax burden. Some states have no income tax, while others have high rates on retirement income. You should examine how a state treats specific retirement income sources.

Many states offer specific tax breaks for retirees. For example, some states fully or partially exempt Social Security benefits from taxation, even if they are taxable at the federal level. Others provide exemptions or deductions for a certain amount of income from pensions, 401(k)s, and IRAs.

A state with no income tax might have higher property or sales taxes. Evaluating the total tax picture, including how these taxes affect your spending and assets, is necessary for an accurate comparison.

State-level estate and inheritance taxes are also a consideration in long-term planning. An estate tax is levied on the total value of a person’s assets at death, while an inheritance tax is paid by the individuals who receive the assets. Only a minority of states impose these taxes, but their financial impact can be substantial.