What Are Good Tax Strategies for Retirement Income – Tips and Guide

Taxes affect your income while you are working, as well as after you retire. According to a recent survey of nearly 130,000 American consumers, an average American pays nearly $10,500 in income taxes annually, which is nearly 14% of an American household budget. It is prudent to build-up a strong corpus for your retired years by investing in the right tools. But it is also extremely critical to ensure that you adopt smart tax strategies to minimize your tax liability during retirement to avoid paying a hefty sum in taxes each year when you retire. High taxes could cause you to outlive your assets sooner than anticipated, ultimately failing your entire retirement plan. Hence, it is advisable to create a tax strategy for your retirement income sooner rather than later to get full benefits in the latter half of life.

Here are some tips that can help you create an efficient tax strategy for your retirement income:

1. Reconsider your investment portfolio

According to experts, retirees must shift their investment portfolio towards more conservative investments as they near their final retirement years. This strategy is not only helpful in preserving your principal but also useful in saving taxes during retirement. Generally, profits from investments, including dividends, capital gains, mutual fund earnings, accrued interests,, attract similar taxes as they did before retirement. Hence, it is suggested to restructure your portfolio to minimize the tax burden from your investments. You can consider investing some money in municipal bonds that are free from federal taxes. Alternatively, you can choose to allocate some funds in qualified stocks since qualified dividends enjoy more favorable tax treatment than ordinary income. Further, you can consult your financial advisor to employ some capital gain offsetting strategies. If you have long-term or short-term capital gains, but your overall income is considerably low, you might qualify for a 0% capital gain tax rate. However, for this, your taxable turnover should not be more than $78,750 and $39,375, in the long and short term, respectively. Also, if you have stocks or mutual funds that are not associated with your retirement accounts, your tax professional can deploy strategies to realize capital gains or harvest losses.

2. Redirect your funds to a Roth account

Even if you have been putting most of your funds in tax-deferred retirement accounts like an IRA (Individual Retirement Account) or a 401(k) account, 403(b) and 457 plans, etc. you are liable to pay taxes on withdrawals. Any income from these accounts is taxed as per ordinary income tax rates instead of long-term capital gain rates at the time of withdrawal of money. The total tax liability depends on the total income, applicable deductions, and corresponding income tax bracket. However, if you apply a suitable tax strategy and redirect your funds from these accounts into a Roth IRA or a Roth 401(k) account, you may be able to save a lot of money. These accounts do not levy any taxes on your savings, receipts, or withdrawals, provided the withdrawal criteria meet specifications of the IRS (Internal Revenue Services). However, apart from other rules, you have to hold these accounts for at least five years before becoming eligible for its tax-free provisions. That said, this conversion is also beneficial in avoiding state taxes. Nearly 22 American states give no exemption on withdrawals from retirement savings accounts like an IRA or a 401(k) account. Hence, it could be more beneficial to roll over your money into a Roth IRA or Roth 401(k) to evade taxes and save more. You must understand the rollover rules and check your eligibility for the same.

3. Be wise about Social Security benefits

Social Security benefits are a considerable support during your retirement years but can also result in heavy taxes if the withdrawals are not planned strategically. However, if you only get Social Security benefits during retirement and have no other source of income, you do not pay any taxes. This is because your total income is below the minimum taxable limit. But if you have additional revenue streams like an IRA or a pension account, the tax rate  If your taxable income is high, a part of your Social Security withdrawals will attract a tax charge. The tax rate is determined by your and your spouse’s retirement income, as well as your tax filing status (married filing separately, married filing jointly, single, etc.). You can determine your total tax liability on Social Security benefits by using the IRS worksheet. As per norms, a retiree with hefty income can pay taxes on nearly 85% of Social Security benefits. That said, some states like Texas and Florida, do not levy any fee on Social Security benefits. Further, some other U.S. states also offer deductions, credits, or limits to reduce your tax burden. With wise tax planning, like reducing your adjusted gross income, limiting the sale of securities, etc., you can minimize taxes on your Social Security drawings.

4. Delay your withdrawals

If you wish to save on taxes, you need to pay attention to how you withdraw your money from your retirement savings accounts like a 401(k), an IRA, as well as from your Social Security. If you draw money from a 401(k) before the age of 59.5, the IRS will levy a 10% penalty on the money that has been taken out. But, if you keep the money in these accounts for a longer period, until you have to make the RMDs (Required Minimum Distributions), the funds grow tax-deferred. The 2019 SECURE Act mentions 72 years as the age for RMDs from an IRA or similar workplace retirement plan. However, the CARES Act 2020 lifted the RMD specifications for 2020. Further, if you delay your Social Security withdrawals, you can push your tax liability to a time when your income will be lower and pay fewer taxes. Moreover, delaying Social Security withdrawals will improve your returns. For example, a person who withdraws Social Security benefits at the age of 68 (one year after the official retirement age) can get returns up to 108% of the total monthly benefits. As per research, an average retiree can enhance the Social Security cheque by more than 50% by delaying withdrawals until 70 years.

5. Invest in a Health Savings Account (HSA)

You can also reduce your tax burden by opting for an HSA.An HSA offers a triple tax advantage. You contribute money before paying any taxes. The money invested grows tax-free, and at the time of withdrawal, you do not pay any taxes on the sum withdrawn. Hence, HSA is a wise strategy to minimize taxes on your retirement income. Every year, the IRS announces contribution limits for HSA, as it does for other retirement savings accounts. For 2020, the upper limit of self-only HSA is $3,550 and for a family is $7,100. However, as per the Revenue Procedure 2020-32, for 2021, for self-only HSA coverage, the upper limit is $3,600, and for family, it is $7,200. So, it is in your interest to maximize your annual HSA contributions to get optimum tax benefits and also be equipped to afford future healthcare costs.

To sum it up

Taxes can be complicated and also difficult to avoid. However, with smart tax-saving tactics deployed well in advance, and some prudent advice from professional financial planners, you may save more of your hard-earned money and adequately support your life during retirement.