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During your working years, you’ve probably used strategies to reduce your tax liability: contributing to tax-advantaged retirement accounts, making charitable contributions, or buying municipal bonds, for example. The importance of tax planning doesn’t diminish as you approach and enter retirement. It arguably becomes even more important, as lowering how much tax you owe can help your nest egg last longer.
While tax strategies should always be tailored to your unique situation — ideally, with the help of a financial planner — the concepts below often help retirees save money.
- Max out contributions to tax-advantaged accounts.
- Understand required minimum distributions.
- Take proportional withdrawals.
- Learn about taxes on Social Security benefits.
- Consider a partial Roth conversion.
1. Max out contributions to tax-advantaged accounts
What you should do. If you haven’t been maxing out your contributions to tax-advantaged retirement accounts — in 2023, that’s $22,500 to 401(k)s and 403(b)s; $6,500 to IRAs — now is the time to start. Those limits climb in 2024 to $23,000 in 2024 for 401(k)s and 403(b)s and $7,000 for IRAs. If you’re 50 or older, take advantage of catch-up contributions: $7,500 for 401(k) and 403(b) plans and $1,000 for IRAs. (Calculator: How much do I need for retirement?)
How this strategy saves on taxes. Contributions to most retirement accounts reduce your taxable income now. Contributions to Roth accounts reduce your taxable income later. Contributions to either account, when invested, grow tax deferred. That means you don’t get a tax bill every year if your account increases in value.
Bonus tip: Hedge your bets about future tax rates by contributing to both a 401(k) or traditional IRA and a Roth 401(k) or Roth IRA. The two account types get opposite tax treatment when you take withdrawals. (Learn more: Retirement savings catch-up: 3 moves)
2. Understand required minimum distributions
What you should do. For each of your retirement accounts, learn if they are subject to required minimum distributions and how RMDs work. For example, traditional IRAs require you to start taking minimum distributions beginning with the year you turn 73. 401(k)s do, too, unless you’re still working. Roth IRAs don’t require any distributions until the owner dies. (Learn more: RMDs explained)
How this strategy saves on taxes. If you don’t take RMDs or if your distributions are too small, you’ll owe a tax penalty of 50 percent of the amount you didn’t withdraw — a huge waste of money. Make sure to withdraw the full amount you’re required to each year, which is generally based on your age, life expectancy, and account balance.
You must take your first RMD in the year when you turn 73, but you have the option to delay it until April 1 of the following year. You might want to delay it if your income will be substantially lower the following year — for example, if you’re still working but about to retire. You may also need to make quarterly estimated tax payments on your retirement account distributions to avoid tax penalties.
Bonus tip: Once you are over age 70 ½, you can make a direct transfer of up to $100,000 from your IRA (other than a SEP IRA or SIMPLE IRA) to a qualified 501(c)(3) charity through what’s called a qualified charitable distribution (QCD). A QCD will satisfy part or all of your RMD requirement and reduce your taxable income, even if you don’t itemize deductions on your tax return. (Learn more: Retiring in 12 months or less? What to do)
3. Consider proportional withdrawals
What you should do. It’s common to have retirement assets in three types of accounts: taxable brokerage accounts, tax-deferred retirement accounts, such as 401(k)s or 403(b)s, and tax-free Roth accounts.
“It is important to time the withdrawals in order to potentially avoid getting bumped into a higher tax bracket and also to avoid making Social Security taxable,” said Vincenzo Villamena, the managing partner of the CPA firm Global Expat Advisors in New York, a boutique CPA firm specializing in tax preparation for entrepreneurs, U.S. expats, and others in special situations.
How this saves on taxes. Typically, a retiree withdraws a certain amount from their portfolio each year. How much could vary from person to person, but a rule of thumb is 4-5 percent of the overall portfolio value each year. (Related: The ideal portfolio withdrawal rate)
The traditional approach is to
- Draw down the money in your taxable brokerage accounts first, incurring little to no tax since the only taxable part of those withdrawals is from capital gains, which are taxed at a lower rate than other kinds of earned income.
- Next would come 401(k) and traditional IRA withdrawals, which will typically incur taxes at ordinary rates.
- When those accounts are depleted, turn to Roth withdrawals, which can generally be taken tax-free.
Overall, this strategy means tax bills are mainly due in mid-retirement years for most people. Also, this overall approach lets money in tax-deferred accounts grow longer.
But a different strategy is emerging where a retiree would withdraw from every account in their portfolio, based on each account’s percentage of their overall savings. So, some money would come from brokerage accounts, 401(K)/traditional IRAs, and Roth accounts each year. This strategy typically incurs a tax bill every year, but the amount can be lower and relatively stable from year to year. And it ultimately may amount to a lower tax bill over the length of your retirement. It could also reduce taxes on Social Security benefits and lower Medicare premiums, since taxable income would be spread out over a greater number of years.
Which strategy makes the most sense will depend on personal circumstances and finances. Many people opt to discuss their options with a financial professional or tax specialist. (Related: Beware sequence of returns risk)
Bonus tip: For retirees in the 15 percent to 20 percent capital gains tax bracket, combining the traditional and proportional withdrawal strategy could result in greater tax savings. Again, consulting with a financial professional or tax specialist would probably help to see if that option is workable. (Learn more: Four reasons why your 401(k) may not be enough)
4. Learn about taxes on Social Security benefits
What you should do. Learn about Social Security’s rules for provisional income.
Provisional income is a measure used by the IRS to determine whether or not Social Security recipients are required to pay taxes on their benefits.
“More of your Social Security benefit becomes taxable the higher your provisional income is,” said Brandon Renfro, an assistant professor of finance at East Texas Baptist University and a fee-only financial professional in Marshall, Texas.
Retirement income such as interest, dividends, and taxable retirement account distributions, combined with your Social Security income, can cause up to 85 percent of your Social Security income to be taxable.
Since qualified Roth distributions are not taxable, they don’t count toward your provisional income. If you can turn more of your retirement distributions into Roth distributions, you can reduce the possible taxes on your Social Security benefits. (Learn more: Filing for Social Security retirement benefits)
5. Consider a partial Roth conversion
What you should you do. “Before you retire, and especially right after you retire, it can make a lot of sense to move some of your retirement money into Roth accounts through what is called a partial Roth conversion,” Renfro said.
A Roth conversion involves moving money from a retirement account whose distributions are taxable — such as a 401(k), 403(b), or traditional IRA — into a Roth IRA. The conversion will generally be taxable, and subject to a 10 percent early withdrawal penalty if you’re younger than 59½, unless you follow specific IRS rules .
How this strategy saves on taxes. Once your retirement savings are in a Roth IRA, they’re no longer subject to required minimum distributions.
“You’ll have to pay taxes on the conversion, but you won’t pay taxes on the withdrawals going forward,” Renfro explained. “This can help smooth out your level of taxable income [in retirement] and potentially drop you into a lower tax bracket.”
Bonus tip: Ladder your conversions before RMDs begin. Instead of making one large conversion of 401(k), 403(b), or traditional IRA funds in a single year, which could trigger a large tax bill — especially if you’re still working — systematically convert smaller amounts over several years. (Learn more: Tips for maximizing your retirement income)
Bottom line
It’s important to preserve your retirement savings by understanding how your decisions about which accounts to withdraw money from and when will affect your tax bill. While taxes are far from the only consideration when dealing with retirement assets, learning the tax rules and savings strategies ahead of time can make a big difference in how much you owe and how much you’re able to keep.
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