People have to make a lot of assumptions when planning for retirement, especially when it comes to estimating taxes. But a simplistic assumption that you’ll be in a lower tax bracket when you retire can lead to problems. To help manage taxes, remember this:
Your tax liability in retirement depends on your taxable income in retirement.
The good news is that once you retire, in many ways, you may have more control of your income than ever before. How’s that? It depends in large part on what you have for savings and the decisions you make.
If you’re newly retired or getting ready for retirement, it’s a good idea to create a strategy to help you limit the amount of taxes you’ll regularly owe. Here are a few ideas to get you started managing your taxes:
1. Cut your spending.
Reducing expenses can cut your taxable income and keep you out of a higher tax bracket during retirement. How? The less you spend, the less you may need to withdraw from your retirement accounts. In turn, reducing your retirement account withdrawals may keep you in a lower tax bracket, which allows you to take advantage of a variety of tax breaks.
2. Put a hold on your Social Security.
Many people are eager to take their Social Security benefits as quickly as they can in retirement. That’s because for many Americans, it makes up a big part of their retirement incomes. But there are advantages to delaying your Social Security benefit if you can.
To help manage taxes, consider drawing on savings you have in a Roth IRA or other after-tax account early in your retirement, and then using Social Security later. This may help reduce your taxable income in the present, while increasing your Social Security benefit in the future. The longer you wait to draw on Social Security, the more money you may receive. In fact, experts estimate that each year you delay, you’ll see an 8% increase in your monthly Social Security check.1
3. Pay off your mortgage before you retire.
Why? If you’re like most homeowners, your mortgage is your highest monthly expense. If you retire before paying off your mortgage, you may have to draw on your retirement savings to keep up with your payments. These retirement distributions could put you in a higher income tax bracket and make living comfortably during retirement more difficult.
4. Load up the truck.
Did you know there are currently seven states that don’t have state income tax? Moving can be a hassle, but if you’re up for it and want to reduce your retirement income tax rate, you may want to look at living in Alaska, Florida, Nevada, South Dakota, Texas, Washington, or Wyoming.2 No? There are also a host of states that help make retirement easier for residents by not taxing Social Security, government, or private pensions.
5. Take advantage of a Roth IRA.
Roth IRAs may offer benefits to retirees looking to lower their tax rate. If you don’t have one already, you can consider converting your traditional IRA or pre-tax 401(k) account to a Roth IRA. Sure, you’ll take an initial hit on taxes with the conversion, but it might be worth it, depending on your needs. Consider the following differences.
- Roth IRAs aren’t subject to the same minimum distribution requirements as 401(k) plans and traditional IRAs.
- Roth IRA contributions and earnings can grow tax-free over time without interruption.
- Since you’ve already paid taxes on your investments up front, you won’t have to pay any taxes when you take that money out.
6. Be generous.
If you have a traditional IRA, you can make charitable contributions from it after you reach age 70½ — which can satisfy your annual minimum distribution requirement. And if you make your donation directly from your IRA to the charity of your choice, your charity gets the entire amount.
Managing taxes in retirement can be complex. But you have choices. To make your decisions, it’s important to understand your options and build a plan that helps optimize your tax situation in your later years.