There’s no doubt that retirement brings many perks, such as having more free time to spend with friends and family. But without proper guidance from an experienced financial planner, you may also discover some unexpected pitfalls, too. A recent Clever Real Estate survey shows failing to understand how much to save up for retirement is retirees’ biggest regret (56%). But 37% of retirees surveyed also didn’t understand how much they’d have to pay in taxes on their retirement savings. If you’re looking for ideas to help reduce your taxes in retirement, keep reading for some valuable tips.
Understanding What Counts as Taxable Income in Retirement
Many people may not realize the tax implications that come with trading a work paycheck for various other income sources. Taxable income in retirement can include any of the following, depending on how and when you decide to use them:
Social Security Income
You can start drawing Social Security income as early as 62, which reduces your amount up to 30% for life. You’ll pay taxes on up to 85%* of your Social Security benefits if your total combined monthly income exceeds:
- $34,000 for an individual, or
- $44,000 for a couple (married filing jointly).
*The exact percentage depends on your combined income as a household. Figures and percentages cited are from IRS Publication 915 for the 2023 tax season.
Annuity or Pension Income
You’ll typically pay tax on pension income at your ordinary income tax rate. Some pensions may offer lump-sum distributions, which can be subject to different tax rules.
For annuities, if you made contributions with pre-tax income, then any distributions become taxable at your usual rate. Otherwise, you will only owe taxes on the part of distributions that represent earnings generated through your account.
Traditional IRAs or 401(k) Retirement Funds
Employers commonly offer these retirement plans by matching a percentage of their workers’ pre-tax income. However, you will pay income tax on withdrawals from tax-deferred accounts in most states once you turn 60.
Capital Gains on Dividends from Non-Retirement Taxable Accounts
Some investment vehicles that pay dividends or interest are fully taxable accounts, regardless of whether you still work or not. Examples of these include:
- Stocks
- Bonds
- Mutual funds
Tips to Reduce Your State Income Taxes in Retirement
- If you have a pension, move to a state where it doesn’t count as taxable income during retirement.
In these 17 states, you will not owe taxes on your pension income:
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- Alabama
- Alaska
- Florida
- Hawaii
- Illinois
- Iowa
- Mississippi
- New Hampshire
- Nevada
- Pennsylvania
- Rhode Island
- South Dakota
- Tennessee
- Texas
- Vermont
- Washington
- Wyoming
- Move to a state with no personal income tax to maximize your retirement income’s value.
Retirees in these states need only worry about paying federal income taxes:
- Alaska
- Florida
- Nevada
- South Dakota
- Tennessee
- Texas
- Washington
- Wyoming
Important: New Hampshire currently taxes interest and dividends worth more than $2,400 ($4,800 for joint filers). However, the state will phase its Interest & Dividends Tax out starting on December 31, 2024.
- Retired military veterans can avoid paying taxes in retirement on VA pension income in these 33 U.S. states.
Those same state income tax rules can benefit military families that rely on survivor or DIC benefits as dependents.
Strategies to Help Reduce Your Federal Income Tax Burden
- Diversifying your savings plans now can help you better control how much of your money goes toward paying taxes in retirement.
Lots of people put money into traditional savings accounts at their local bank or credit union. Others may prefer investing in stocks, federal or municipal bonds, or opt for a high deductible health savings account. But no matter where you decide to park your money, spreading it out isn’t just safer in the long run. It can also potentially help reduce your tax liability once you start using that money for retirement income.
Do you know the benefits that come with a traditional IRA vs. Roth IRA retirement accounts? What federal taxes will you owe for early 401k withdrawals before age 59? If not, you’re a great candidate to attend one of our free educational workshops in your area. An experienced financial services industry professional in your community can help you make sense of your options.
- Keep an eye on anything that might move your income into a higher tax bracket during each calendar year.
If you’re in a lower tax bracket today but need to pull money out for home repairs, watch out! You could get hit with a higher tax rate when it’s time to file with the IRS next year.
Start tracking your individual tax rate now, and you’ll have a much easier time once you’re ready to retire.
- Tap into your taxable accounts first for retirement income so tax-advantaged accounts can keep growing over time, if possible.
Here’s an example: You bought a house last year, but also have money in a Roth IRA and a traditional 401k. Short-term capital gains taxes kick in if you sell your piece of real estate within 12 months at a 25% tax rate. Depending on your federal income tax rate, a 401k withdrawal may be more financially advantageous. Meanwhile, tax-free income from a Roth IRA only becomes possible after you own that retirement account for at least five years. You’ll want to draw money from those accounts last, so your tax-free balances can continue to accrue.
Need money to pay for a large healthcare-related cost, such as surgery or hearing aids? A health savings account covers qualified medical expenses tax-free without impacting your adjusted gross income.
- Realize that how long you own certain investments will impact your taxes in retirement.
You’ll pay more in short-term capital gains taxes on investments you’ve owned less than one year, for example. Another thing to consider? Moving retirement funds from a traditional 401k into a Roth IRA several years before you plan to stop working. Planning to downsize once your adult kids move out and establish their own families? Consult a tax advisor before making any moves so you understand how it may potentially impact your retirement income.
- Plan to start making withdrawals from certain retirement accounts by the time you turn 73 years old.
The federal government passed the SECURE Act 2.0 in 2022, which mandates something called required minimum distributions (RMDs). This rule also applies to anyone turning 75 after December 31, 2032, and it affects the following plans:
- Employer-sponsored retirement plans (i.e., 401k, 403b, 457b and profit-sharing plans)
- Traditional IRAs
- IRA-based plans, such as SEPs, SARSEPs and SIMPLE IRAs
RMD rules do not increase taxes in retirement for withdrawals made from ROTH IRAs, which remain fully tax free.
Smart Tax Strategies for People Who Want to Leave Something for Their Children
- Start transferring wealth to your loved ones while you’re still alive by making annual tax-free gifts.
Giving away certain assets now can help reduce the value of your taxable estate in the future. You can also provide tax-free cash gifts to your beneficiaries up to a certain amount every year.
- Consider working with an estate planner to help minimize any inheritance taxes your heirs might owe.
Protecting assets to pass them along to the next generation is often top of mind as we approach our retirement years. Working with an attorney or tax professional in your state can help you draft a smart estate planning strategy that also minimizes your taxes in retirement.
Key Takeaways: Minimizing Taxes in Retirement
- A financial advisor can help you craft a tax-efficient retirement plan that fits your unique income and lifestyle needs.
- Certain investment and savings plans carry a higher tax burden than others once you start making withdrawals.
- Shifting money into tax-advantaged accounts before you stop working can help you minimize taxes in retirement.
- Federal law requires you to make minimum withdrawals from certain retirement accounts once you turn 73 years old.
- Choosing to draw Social Security benefits before you turn 67 will permanently reduce your monthly payments for life.
- Some states tax retirement income, while others do not. It all depends on the type of benefit, account, or investment vehicle you draw money from during retirement.
