Managing Taxes in Retirement: Tips and Strategies

Retirement comes with plenty of unknowns. In fact, nearly half of retirees underestimate how long they will live by five years. That means whatever money they have in their retirement accounts has to stretch even farther. In order to make the most of their hard-earned money and their retirement years, it’s important for retirees to know how taxes in retirement can impact their financial plan. This knowledge could mean the difference of thousands of dollars that stay in their own pocket or bigger checks written to the IRS. 

At Clear Money Path, we follow a three-step process to retirement planning—plan well, invest well, and finish well. Part of investing well to prepare for retirement involves nailing down your income. Not only does this mean finding the right investments and creating an ideal portfolio, but it also means minimizing the taxes on your withdrawals.

Don’t forget, Clear Money Path does not provide tax advice, but we build a plan in concert with your tax advisor to help save you time and money! In this blog, we’ll explore how to manage taxes in retirement, from pulling money out of your investment accounts to making the most of Social Security benefits. 

Understand Your Retirement Income Sources

Retirees save within numerous accounts to prepare for retirement. Typically, these become sources of income and fall into three categories: taxable distributions taken from pre-tax savings plans (401(k)s and IRAs), withdrawals subject to income and capital gains taxes (from brokerage accounts and trusts), and non-taxable distributions (from Roth IRAs and Roth 401(k)s).

If you have unique assets like business investments, real estate, or life settlement funds, ask your financial advisor about how these will be taxed when you begin withdrawing. Social Security distributions are also taxed differently, even from person to person based on when a retiree was born. From the options above, there is an optimal time to take from the different accounts so you can manage taxes effectively. 

Take Advantage of Tax-Advantaged Accounts

From the three types of income sources available to you, some accounts are more tax-advantaged than others. A tax-advantaged account is any retirement account that provides you with a tax benefit. It is a blanket term for either of the following: 

• Pre-tax, or Tax-deferred: The contributions you make to a pre-tax account have not yet been taxed. Taxes are deferred until the time of distribution. 
• Tax-exempt: Contributions in a tax-exempt account have already been taxed, and are not subject to taxes upon withdrawal. 

If you’ve made pre-tax contributions to an IRA or 401(k) account, you will be taxed on these contributions at the time of withdrawal, so it’s generally better to hold off withdrawing from these accounts until a Required Minimum Distribution (RMD) is mandated at age 73.  

Required Minimum Distributions (RMDs)

As mentioned, a caveat to withdrawing funds from your investment accounts is understanding the rules for Required Minimum Distributions (RMDs). According to the IRS, IRA account holders are required to withdraw a certain amount from their accounts each year once they turn 72 or 73, depending on their birthdate. 

Tax-Advantaged Investments

Some investments are tax-advantaged as well. For example, income from certain municipal bonds is often tax-exempt, and an investor will receive interest on the bond for the duration of the bond’s life.  However, yields on municipal bonds are lower than their taxable counterparts, so you’ll need advice regarding the best selection according to your tax bracket. Another example is depreciation from real estate investments. Depreciation deductions may be a helpful tool in an investor’s tax-savings strategy and may offset the overall tax impact, even in light of potential capital gains taxes from the sale of a property. 

Consider Tax Diversification

Now that you know the types of accounts available and how they are taxed, you can make wiser decisions about your withdrawal strategy. Of the three sources of retirement income we discussed, it may seem like the simplest choice to create a portfolio of untaxed accounts. However, a financial advisor would warn you against “putting all your eggs in one basket.” It’s important to diversify your sources of retirement income and know when to withdraw from these accounts so you are maximizing savings and minimizing the taxes you pay. 

A healthy combination of the three different kinds of accounts can help you nail down your income so you are aware of what income streams you have available to you, which ones will be taxed more heavily, and when to take distributions in a tax-efficient manner. Simply stated, everyone needs an income distribution strategy. It’s best to talk with your financial advisor about the right strategy for you. 

Manage Social Security Benefits

Depending on your income level, you may only be taxed on 85% of your Social Security benefits in retirement. This applies even if you still continue to work.

Despite the taxes on Social Security benefits, there are other ways to maximize the benefits you receive. Talk with your financial advisor to help you decide about the best strategy for taking your benefits. According to the Social Security Administration, full retirement age (FRA) varies between age 66 and 67 depending on what year you were born. If you begin receiving these benefits before full retirement age, there is an 8% deduction in the amount you will receive.  However, you can also delay your retirement to age 70 to optimize your retirement benefits. For every year you delay receiving benefits from your FRA, your benefits will increase by 8%. 

Understand State Taxes in Retirement

State taxes are inevitable in retirement unless you live in one of the seven states without personal income tax. While some states are tax-friendlier than others, you might also expect your retirement earnings to be taxed by your local government. 

Consult a Tax Professional

Knowing the ideal combination of which accounts to put money into, which to withdraw from, and when to withdraw is complicated. Every retiree has a unique situation that requires careful analysis and a plan that is flexible when it comes to changes in tax laws, market performance, and even your health and that of your spouse. A tax professional can help you navigate your situation and guide your decision-making when it comes to managing taxes in retirement. 

Here are a few things to keep in mind when consulting a tax professional. 

• Understand your needs. It will be helpful for a tax professional to know when you and your spouse plan on retiring and what sort of retirement accounts you currently have. That will show them how much you may or may not pay in taxes in retirement. 

• Look for credentials. Going to your local tax preparer might not be the wisest choice for guidance on taxes in retirement. Certified Public Accountants (CPAs), or some lawyers with certifications in taxation, are typically more well-versed in tax-minimizing strategies. 

• Compare the cost. Tax professionals will charge fees based on the number of hours worked or the amount of forms they have to file. Explore and compare all the costs from each tax professional before making a decision. 

Trust Your Retirement Income Strategy to the Experts 

In this blog, we talked about how to manage taxes in retirement, from choosing the right accounts to knowing when to withdraw. As an already busy individual getting ready for retirement, keeping track of it all can be difficult. Let Clear Money Path be the quarterback for your retirement income strategy. Clear Money Path is not a tax advisor, but we can help you create a financial plan and partner with a CPA to help you minimize your taxes—without the excessive fees. For a free consultation with an advisor, schedule a call with us today!