Smart tax planning can save you money in retirement. It primarily depends on understanding how tax brackets work. Then, based on your income and tax bracket, consider different tax planning strategies such as taking deductions, investing in tax-deferred accounts, or even claiming losses to offset capital gains.
How Tax Brackets Work
Your income tax bracket mainly depends on two key factors – your income and your marital status. Income tax is progressive, meaning the tax rate increases as income increases. The income thresholds for tax rates also change based on whether you file single, jointly married, separately married, or as a head of household.
Strategies for Taxable Income Over $85,000 for Married Couples, $42,000 for Individuals
Taxpayers can find ways to reduce income from higher tax brackets to lessen their tax bill. Here are some ways to shift income to a lower bracket:
Asset Allocation
Asset allocation or rearranging your investments to reduce taxable income is a sound strategy for lowering taxable income. You want income-generating investments from interest reserved inside retirement accounts, and investments that generate capital gains and qualified dividend income outside retirement accounts.
Tax-Deductible Contributions to Retirement Plans
For those earning high incomes, tax-deductible contributions to retirement plans are a great idea if you’re in the 32% or 35% tax bracket. Why? When you retire and start withdrawing money, your tax bracket will likely be lower, in the 12% to 24% range. If you can deduct money today at 35% and pay taxes later at 12%, that results in significant savings.
Increase Contributions to Retirement Plans
Each year, the IRS announces new contribution limits for 401(k) plans, IRAs, and other retirement plans. Be sure to adjust your salary contributions to max out the amount in your plans. For instance, in 2022 and 2023, the maximum contribution for a 401(k) plan is $20,500 and $22,500, respectively.
Utilize Tax Losses
When you sell investments for a profit, you are liable to pay capital gains tax on that profit. This liability can be reduced by selling other investments at a loss, using a strategy called tax loss harvesting. If the capital loss exceeds the capital gain, individuals can deduct a capital loss of up to $3,000 ($1,500 for married couples). If the net capital loss is greater than $3,000, you can carry that loss over to offset capital gains in future years as well.
Strategies for Taxable Income Less Than $85,000 for Married Couples, $42,000 for Individuals
Falling into lower tax brackets based on your income can change how you approach tax planning. Here are some strategies for married couples earning less than $85,000 and individuals earning less than $42,000 to adopt:
Using Low-Income Years to Fund Tax-Free Roth Accounts
You may not need to contribute to a tax-deductible retirement account. Instead, fund your Roth account, or make Roth contributions to your 401(k) plan. In years when your taxable income will be low, Roth IRA or Roth 401(k) contributions are advantageous.
For example, there was a real estate agent who usually contributed to her tax-deductible 401(k) plan. At the end of a slow year, she looked at her tax situation and realized she would be in a low tax bracket that year. It didn’t make sense for her to make the tax-deductible contribution to save 10% in taxes now, then withdraw in 10 years and pay 12% taxes at that time. So she contributed to a Roth IRA instead of making tax-deductible contributions to her 401(k) plan.
Withdrawal
Funds from IRA Accounts
For those who are over 59 and a half, you might consider withdrawing funds from IRA accounts during low-income years, even if you’re not required to. Here’s why this could work. After accumulating detailed deductions, such as mortgage interest and healthcare expenses, some retirees may have additional deductions from income. In years when this happens, it can be a great opportunity to withdraw funds from retirement accounts and pay taxes at only 12% or 22%.
Alternatively, many retirees follow the traditional wisdom and let tax-deferred accounts grow until they are forced to take the required minimum distributions (RMDs) for the year they turn 72 (70 and a half if you reached age 70 and a half before January 1, 2020). If you wait until age 72, the minimum required distribution could be large enough to push additional income into a different tax bracket.
By withdrawing funds in years when taxable income is low, you can avoid paying an additional 10% to 15% tax on later withdrawals.
Converting a Traditional IRA or Part of It to a Roth IRA
You might consider converting your IRA account, or part of it, to a Roth IRA to maximize your tax savings in years when taxable income is low. Roth IRA accounts are funded with money that has been taxed upfront and provide tax-free withdrawals if certain conditions are met. Traditional IRA accounts are funded with money that will be taxed later.
Since your IRA funds have already been taxed, the conversion to a Roth IRA will be subject to regular tax rates. If you time it correctly for a year when your taxable income is lower than usual, you may be able to save on some taxes.
Frequently Asked Questions (FAQs)
What tax planning strategies can you use for capital gains?
You will incur capital gains tax if you sell a capital asset, such as an investment, at a profit. The simplicity of holding the asset for more than one year can reduce your tax bill. Investments held for less than a year are subject to capital gains tax at regular tax rates. Investments held for more than a year are subject to lower capital gains rates. Another way is to offset your capital gains tax liability by selling other investments at a loss or utilizing tax-loss harvesting.
Who can I consult for retirement tax planning strategies?
It’s a good idea to get help from a professional for your tax planning. You can work with a Certified Financial Planner (CFP) or a financial advisor to design a financial plan that works for your situation and is also tax-efficient.
Source: https://www.thebalancemoney.com/tax-planning-strategies-to-shift-income-to-lower-brackets-2388990
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