Retirement is an important period in a person’s life, where they spend most of their time working, saving, and planning for retirement. The last thing you want is to give a large portion of your savings to the taxman. But that’s what will happen if you enter retirement without making tax planning a crucial part of your retirement savings. Financial advisors will tell you that earning and saving is only part of your retirement planning. The other part is working with a financial advisor to make your savings as tax-efficient as possible.
Basics
Do you know what is taxable and what is not? If you think everything is taxable, you are largely correct. But to build a tax planning strategy for retirement, you need to go deeper. Proper tax planning involves knowing exactly how much taxable income you are earning. Here are the basics:
Earned Income
If someone pays you, you are required to pay taxes. This includes money you receive as a salaried or hourly employee, as an independent contractor, or just from a side job. It includes income paid to you by someone else, income you earn from work done for a third party, income earned outside the United States, bonuses and awards, and even that special company trip as a reward for meeting your sales target – all of it is taxable.
Regular Investments
If you sell investments, any profit is taxable in the same year and counts as part of your annual income. This may include brokerage accounts, real estate, bank products, and a variety of other assets. IRA accounts can be either Roth or traditional. Contributions to a Roth IRA are taxed at the time of contribution, and do not provide any upfront tax advantage. Traditional retirement accounts are taxed upon withdrawal and come with an upfront tax deduction since you do not pay any taxes on the money used for the contributions.
Keeping Yourself in the 12% Tax Bracket
How would you like to pay zero taxes on any capital gains you receive? You can do this by keeping your income below $80,000 if you’re married, or $40,000 if you’re single. The 12% tax bracket comes with a 0% tax rate on capital gains.
Even if you usually earn more than the limits mentioned above, most retirees will have years where they earn less, or they can carefully plan to take advantage of Roth accounts which have no tax implications.
The key is to accurately predict your taxes and get as close to the limit as possible without exceeding it. If you are married and find you only have $60,000 of taxable income, pull $18,700 from your retirement accounts – even if you don’t need it – and save it for future years. Remember the list we created above? Don’t forget any less common ways you can make income. If you move into the next tax bracket, those tax-free gains will be wasted.
Roth Conversions
Each year, look at your income and convert as much as possible into a Roth IRA or 401(k) if your company offers this option. You don’t want to push yourself into a higher tax bracket with the conversion, but remember that paying taxes while in a lower bracket is better than paying taxes later when you have higher income. Just like the 12% tax bracket above, whatever tax bracket you belong to now, convert as much as possible without moving into the higher tax bracket.
Diversification
Your Income
Investment professionals understand that diversification is key to managing the natural shifts in the performance of various investment accounts. If one investment is struggling, another may be performing excellently.
The same strategy works in retirement planning. If you have a mix of taxable and tax-deferred accounts, you can take advantage of the tax-deferred accounts when your income is relatively high and the taxable accounts when it is low.
Utilizing Tax Losses
Losses are part of investing. Not everything is a winning investment, but losses aren’t entirely bad. Losses can offset any taxes you owe when you realize gains from your investments. If you have some losing investments in your portfolio that you wanted to get rid of anyway, selling them at a loss can reduce your capital gains liability.
Utilizing tax losses can be a useful tool for reducing your capital gains liability, but it will only work with some investments. For instance, it may not generally work with any tax-protected retirement accounts.
Stopping Work
Your Social Security benefits may be taxable. It depends on your income. If your total income is below $25,000 if you are single, or below $34,000 if you are married, your benefits are not taxable. If you exceed these thresholds, the IRS applies a formula that can make up to 85% of your benefits taxable.
If you want to avoid paying taxes on your benefits: stop working, work just enough to stay below the threshold, or defer receiving benefits as long as you can. Once you reach age 70, it no longer makes sense to delay benefits.
Disaster Relief
While it doesn’t affect retirement strategies for most individuals, the IRS sometimes offers help to those who have suffered losses due to natural disasters. For example, some victims of the California wildfires in 2018 can claim uninsured or unreimbursed losses in the year the loss occurred. This applies to personal losses and business losses and can open up possibilities for some of the strategies mentioned above.
As your savings grow and your wealth accumulates, tax planning can become so complex that you can’t do it alone. You may need help from a financial advisor, a tax attorney, and possibly an estate planner. While there are many articles to help you understand the basics of tax planning, don’t hesitate to seek help from a professional before you reach retirement age.
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Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
Tax Foundation. “2020 Tax Brackets.”
Source: https://www.thebalancemoney.com/how-to-minimize-taxes-in-retirement-4155294
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