Though taxes might not be the first thing you think of when it comes to how you want to spend money in retirement, planning strategically can mean more funds for the things you love. That's why when you're budgeting for retirement, it's important to factor in how much of your money will be going to the IRS each year. Reducing your taxes after retirement can help you reduce the savings you need to retire in your state.
Not all states are created equal when it comes to taxes in retirement. Seven states have no income tax at all, and Tennessee and New Hampshire only tax interest and dividends.
On the other end of the spectrum, California has a top tax bracket of 13.3 percent, meaning the Golden State isn't topping the list of retirement-friendly places to spend your golden years. You almost certainly have other factors to consider when deciding where you want to spend your retirement years aside from which places are tax-friendly states for retirees, but it could be an important factor.
If you haven't finished working yet, consider whether you should be contributing to a pretax retirement account — like a traditional IRA or 401k — or an after-tax retirement account like a Roth IRA or 401k. If you expect to have more taxable income once you retire — whether that's from dividends, Social Security payments or selling investments — you can reduce your taxes by contributing to a Roth account so the distributions won't be taxed.
Or, if you expect that income tax rates will increase in future years, convert a portion of your retirement savings to a Roth IRA. You'll pay taxes in the year of the conversion, but the later withdrawals from the Roth account will be tax-free.
If you are covered by a high-deductible health insurance plan, you're allowed to contribute money to a health savings account each year. The money in the HSA grows tax-free and comes out tax-free as long as you use the distribution for medical expenses. The IRS permits you to roll money from your traditional IRA to an HSA, tax-free, up to your contribution limit for the year.
With a traditional IRA, your distribution is taxed even if you're using the money for medical expenses. This is literally a once-in-a-lifetime opportunity, as the IRS rules limit you to just one IRA-to-HSA rollover during your lifetime.
4. Withdraw Extra From Tax-Deferred Accounts in Low-Income Years
When you take money out of a tax-deferred retirement plan, you pay income taxes on the distributions at your marginal tax rate. The higher your marginal tax rate, the higher your tax bill on the distribution.
For example, if you are in the 10 percent tax bracket, a $10,000 distribution from your traditional IRA costs you $1,000 in taxes. But that same $10,000 distribution costs you $2,400 in taxes if you have more income and fall in the 24 percent tax bracket.
During years that you have more taxable income — such as when you sell stocks that generate large capital gains — minimize your distributions from pretax accounts.
If you make charitable contributions during the year and you're over 70.5 years old, you can use your required minimum distributions from a traditional IRA to make the donations. You can exclude up to $100,000 from your taxable income by giving this way.
Making charitable contributions directly from your required minimum distributions means you receive a tax benefit for your contributions even if you don't itemize. In addition, the income isn't included in your taxable income for the year, which could mean less of your Social Security benefits are taxed.
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6. Invest in Tax-Free Bonds
As people age, many begin moving a larger portion of their portfolios from stocks to bonds to reduce risk. Some bonds are exempt from certain types of taxes. For example, federal bonds are exempt from state income taxes. Similarly, state and local bonds, or municipal bonds, are exempt from federal income taxes and sometimes state and local taxes, as well.
Just keep in mind that tax-free bonds often pay a lower interest rate than taxable bonds. As a result, you might be better off getting a higher interest rate and paying taxes.
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7. Strategically Withdraw From Roth Accounts
Roth retirement accounts such as Roth IRAs and Roth 401ks let you take qualified withdrawals in retirement without paying any taxes on the distributions. Because these withdrawals won't push up your taxable income, you can take out extra from your Roth accounts in years when you already have significant taxable income.
For example, say you sold your home because you're downsizing to a smaller one and you'll have a six-figure capital gain as a result. Taking distributions from your Roth accounts rather than your traditional retirement plans could lower your taxes.
As your income shifts from earned income to capital gains income, you have a little more control over when you have to recognize income and losses on your tax return. This issue gave rise to a tax-reduction strategy known as tax-loss harvesting.
Essentially, the idea is that in years when you have higher income, you sell investments that have not done so well to offset some or all of that income and lower your tax bill. The IRS imposes certain rules that affect what you can do, so you should talk to a financial planner or accountant to help.
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9. Bunch Itemized Deductions
You might be able to save on your taxes by bunching your deductions if your itemized deductions for the year are fairly close to the standard deduction. You typically write off deductible expenses in the year you pay them.
For example, medical expenses are deductible in the year you pay them, so if you have surgery near the end of the year, if you pay the bill in December 2018 the deduction goes on your 2018 tax return. But if you pay in January 2019, you must deduct it in 2019. By lumping your deductible expenses in the same tax year, you can itemize one year and then the claim the standard deduction the next year, when you have minimal deductible expenses.
Cutting your tax bill isn't quite as easy as skipping your morning latte or calling your cable company and canceling your subscription. Even so, lowering your living expenses means you'll need to withdraw less money from your taxable retirement accounts during the year. Not only does this mean more money stays in your bank account, it also means you have less taxable income — and therefore, lower taxes.