A stable income is critical to a comfortable retirement – as is limiting the amount of that income that you give to Uncle Sam. Maximizing retirement income and minimizing taxes requires advance planning – as illustrated in these seven tips.
1. Use a Roth IRA
Because Roth IRAs are funded with post-tax dollars, they are flexible retirement income sources and excellent for plugging retirement income gaps. You may draw contributions out at any time and earnings may be withdrawn tax-free if you are at least age 59-1/2 and have had the account for at least five years.
Roth IRA contributions are less attractive when you are in higher-earning years where a high tax bracket applies. Contribute to a Roth IRA when tax conditions are favorable, or convert a traditional IRA to a Roth IRA in a year where your adjusted gross income (AGI) is low, taking the tax hit while you’re in a lower tax bracket.
2. Balance Social Security Benefits and Earnings
If your combined income, defined as adjusted gross income (AGI) plus non-taxable interest plus half your Social Security benefits, is above certain thresholds, either 50% or 85% of your Social Security benefits are subject to income tax. Balance out your income during retirement with income from a Roth IRA, which does not increase your AGI. “The thresholds where you start getting tax paid on Social Security benefits haven’t changed in well over 20 years,” says Betterment Head of Tax Eric Bronnenkant. “Assuming that everything else in your life rises with inflation, then more and more people are having a greater percent of their Social Security subject to tax and are in an exceptionally higher tax bracket. There haven’t been any changes, even with the new tax law, about raising the thresholds. It’s unfortunate that they haven’t been adjusted at all in a really long time.”
Note that if you take benefits before full retirement age, you are subject to other earnings limits that reduce your Social Security benefits proportionately to the amount that you earn.
3. Manage Your Retirement Account Withdrawals
At age 70-1/2, you must take a required minimum distribution (RMD) from each traditional IRA and 401(k) retirement account. However, you can take out funds beginning at age 59-1/2 without penalty.
Make sure that you spread out withdrawals to avoid having to take an overly large withdrawal that puts you in a higher tax bracket. Calculators are available to help you estimate RMDs for your accounts.
Regardless of where you plan to retire, the number one factor in ensuring that you can retire on your terms is your 401(k). Make sure that your 401(k) is maximizing its potential with this free analysis that checks your fees, fund mix, and other factors to help you hit your retirement goals.
4. Take Advantage of Capital Gains/Losses
Capital gains are an excellent source of retirement income. They are taxed at a lower rate than employment income and are not subject to Medicare/Social Security taxes. Poorly performing stocks can be sold off at a loss for “tax harvesting” purposes, neutralizing other gains. By managing your stock portfolio wisely, you can draw regular income with a lower tax burden.
5. Don’t Forget About Your Home
If you plan to sell your home and downsize in retirement, you may be able to exclude some of the sale profits from taxes (up to $250,000 for single filers and $500,000 for married filing jointly) – as long as you’ve lived in the home for at least two of the five years preceding the sale.
6. Make Charitable Contributions
You can make charitable contributions of up to 60% of your AGI, raised from 50% by the Tax Cuts and Jobs Act. This is an excellent way to lower taxes and redirect any RMDs that will place you in a higher tax bracket.
7. Estimate Your Income and Tax Brackets over Time
This is the glue that holds all of the above elements together. Lay out all of your expected income streams over the years, estimate your tax bracket in those years, and shift income sources around to minimize the tax burden. Aim to bring your income just up to the limit of your expected tax bracket but not beyond that mark.
A simple spreadsheet can help you identify the best time to file for Social Security benefits, and whether to take retirement program distributions early or delay them to retirement years with presumably lower tax brackets.
Remember that in high-tax bracket years, a dollar of Social Security benefits is more valuable than a dollar of traditional retirement account distributions because it’s predictable and no more than 85% of it can be taxable.
The key to minimizing taxes in retirement is sound planning before you reach retirement age. Start early and review your plans periodically, making adjustments along the way as your life circumstances change. You’ll be more likely to enjoy a comfortable and satisfying retirement with as small of a tax burden as possible.
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