How to Reduce Your Tax Bill During Retirement

You can implement a variety of strategies to make retirement more affordable: such as downsizing your home, delaying Social Security benefits, or even working part-time. Another fine option is to avoid padding government pockets unnecessarily by minimizing your tax bill.

Live in a tax-friendly state

The list of the most tax-friendly states will, to some extent, vary based on your own specific financial circumstances. This decision will also involve several variables including the source and dollar amount of your retirement income and the value of assets you want to leave for your heirs.

For example, if you’re like many Americans who need to rely heavily on Social Security during retirement, you want to avoid living in states that tax your benefits—since every dollar counts. States that impose some form of Social Security taxes include Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, Rhode Island, Utah, Vermont, and West Virginia.

Other categories of state and local taxes to consider are those that can reduce the quantity of your retirement sources such as your IRA and 401(k), as well as property and sales taxes.

Maximize Roth IRAs

Contributions you make to a Roth IRA account are funded with after-tax dollars; thus, your money grows tax-free and you can take tax-free withdrawals on qualified distributions in retirement. Therefore, if you haven’t yet opened a Roth IRA or reached the contribution limits of your existing Roth IRA, you should definitely do so: as it’s an easy way to reduce taxes in retirement.

Another option to explore is a Roth IRA conversion, meaning a transfer of all (or part) of your balances from an existing traditional IRA, SEP, or SIMPLE IRA into a Roth IRA. One of the most common reasons to convert a traditional IRA to a Roth IRA is to enjoy the option of tax-free withdrawals in retirement.

Additionally, investors often choose Roth IRA conversions to avoid required minimum distributions (RMDs): meaning the amount of money, specified by the IRS, you must withdraw from your account (generally starting at age 73 in 2023). Unlike traditional IRAs, Roth IRAs aren’t subject to any RMD rules—so you aren’t required to make any withdrawals at any point during your lifetime. As a result, the money in a Roth IRA can remain in the account and continue to grow tax-free.

Implement a withdrawal strategy

Knowing how much money you can afford to withdraw isn’t enough; you’ll also need to know how and when to withdraw from each type of account (e.g., taxable, tax-deferred, and tax-free accounts). Doing so can help minimize the amount of taxes you’ll pay out in a given year.

For example, it may make sense for you to consider withdrawing taxable money or conducting a Roth IRA conversion for your living expenses while you remain in a lower tax bracket.

Keep in mind qualified charitable distributions (QCD)

A QCD is a direct IRA fund transfer—payable directly to a qualified charity—as outlined in the Internal Revenue Code. The qualified charitable distribution rule allows owners who are at least 70½ years old to transfer up to $100,000 from their traditional IRA account to charity on an annual basis to satisfy some (or all) of their RMD requirements.
The most significant QCD benefits are tax-related: because unlike regular RMD withdrawals, qualified charitable distributions are excluded from your taxable income and can therefore prevent some people from moving into higher tax brackets.

As a result, QCDs can potentially help taxpayers remain eligible for specific tax credits/deductions and avoid exposure to Medicare surcharges and Social Security taxes.

Consider tax-free investments

A municipal bond (also called a “muni”) is a type of debt security issued by a city, county, state, or other government entity to fund expensive and long-term capital projects such as highway, school, airport, and bridge construction. The largest benefit of investing in a municipal bond is the corresponding tax break. More specifically, the interest you earn on a municipal bond is typically exempt from Federal taxes—and if you live in the state where the bond was issued, you are sometimes also exempt from state taxes.

Treasury bonds are essentially risk-free and offer fixed-rate interest payments with a maturity range of 10 to 30 years. These types of investments are often exempt from both state and local taxes.

Familiarize yourself with health savings accounts

A health savings account, or HSA, is another worthy investment to consider as you navigate taxes in retirement. These types of accounts allow you to set aside money for medical expenses on a pre-tax basis (via payroll deductions or using after-tax money and then claiming contributions as a tax deduction during tax time). You can then use these funds to cover deductibles, copays, and other medical-related expenses.

Several benefits are associated with HSA investments, the largest being the absence of a deadline to use your funds: so any money left in your account at the end of each year simply rolls over and will remain in your account indefinitely until it is used. In addition, money in the account grows tax-deferred and will never require you to pay taxes on the same—provided you spend on qualified health costs.

Pay off your mortgage

Housing costs—which include mortgage, rent, property taxes, insurance, maintenance, and repairs—represents the largest expense for retirees. More specifically, the average retiree household pays an average of $18,872 per year ($1,573 per month) on housing expenses, comprising over 36% of annual expenditures.

Paying off your mortgage can help save on taxes by potentially reducing the amount you’ll need to withdraw from traditional IRAs or other retirement accounts subject to taxes.

In sum: steps to minimize your taxes in retirement

Average retiree household expenses (meaning households led by someone age 65 or older) add up to over $52,141 per year (or about $4,345 per month) and will only increase over time. Since every dollar matters, you’ll want to make sure you minimize what you pay in taxes, accordingly.

———

Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.