Everything changes in retirement—including how you pay taxes. Many new retirees are surprised by how high their tax bill can be. To avoid any unwelcome surprises come tax time, proactive tax planning is a critical component of retirement planning.
Luckily, it’s possible to accurately estimate your tax bill beforehand, making it easier to plan accordingly. By estimating your tax bill in retirement, you can budget effectively to make sure that taxes don’t wreak havoc on your financial plan.
Know your income sources (and how they’re taxed)
Different income sources are taxed in different ways during retirement. The most common sources of income for retirees include Social Security income, investment income, and retirement income.
If you file as an individual, you may have to pay income tax on up to 50% of your benefits if you make between $25,000 and $34,000, and on up to 85% of your benefits if you make above $34,000.
If you file a joint return, you may have to pay income tax on up to 50% of your benefits if you and your spouse have a combined income between $32,000 and $44,000, and on up to 85% of your benefits if you make above $44,000. If you are married but file separately, you’ll most likely have to pay taxes on your benefits.
In the above examples, “combined income” refers to the sum of your adjusted gross income, nontaxable interest, and half of your Social Security benefits. No matter your income level, you’ll only pay tax on up to 85% of your Social Security income.
Investment income is also subject to taxes, although it is often taxed at a more favorable rate than traditional income. If you sell all or a portion of your investments before or during retirement, your profits will be subject to a capital gains tax.
If you sell an investment that you’ve held for less than a year, your profits will incur a short-term capital gains tax. Profits from investments that you’ve held for longer than a year are subject to a long-term capital gains tax. These tax rates vary depending on factors including your filing status and your taxable income. In 2021, the short-term capital gains tax rate ranges from 10% to 37%, while the long-term capital gains tax rate varies from 0% to 20%.
Dividends. There are two types of dividends: qualified and non-qualified. Qualified dividends are taxed at capital gains rates. However, non-qualified dividends are taxed at ordinary income rates.
When it comes to retirement planning, there are a variety of strategies that can be helped to reduce taxes on investment income during retirement. These include tax-loss harvesting and strategic portfolio rebalancing.
Retirement accounts that may be subject to taxes include 401ks, IRAs, pensions, and annuities. Sources of income including 401ks, traditional IRAs, and pensions are taxed as ordinary income, with rates varying according to your tax bracket and filing status.
Other types of retirement savings accounts, such as Roth IRAs, and Roth 401ks, don’t incur any income tax, since they are composed of after-tax retirement contributions. If you use HSA savings for qualified medical costs, these funds generally aren’t subject to taxes. Taxes may apply to any annuity distributions you receive depending on your specific plan.
Proactive tax planning can help
Proactive tax planning is a key component of comprehensive financial planning. Not only can proactive tax planning save you a headache come tax time, but it can also help you to minimize your tax burden while maximizing your income during retirement.
Tax planning has both long-term and short-term benefits, which makes it an important part of financial planning starting well before retirement. In the short term, annual tax planning can help you to identify ways to save on your taxes each year. In the long term, tax planning can help you strategically reduce your lifetime tax liabilities by minimizing taxable income.
Tips to effectively manage your tax bracket
There are a variety of strategies for managing your tax bracket in retirement to minimize your tax burden. These strategies can help you to increase your tax efficiency and protect your retirement savings by reducing the amount of income that is subject to tax.
Buy and sell investments strategically
You should come up with a plan for strategically buying and selling your investments in retirement. This can include strategies such as portfolio rebalancing and tax loss harvesting to minimize taxable income. Depending on your retirement assets, you should carefully consider strategies for making withdrawals from brokerage accounts and liquidating valuable assets like real estate.
Save in accounts with different tax treatments
Another way to effectively manage your tax bracket in retirement is to save in accounts with different tax treatments. This includes tax-exempt savings accounts like Roth IRAs and Roth 401ks and tax-deferred accounts like traditional IRAs and 401ks.
Capitalize on unique opportunities
Depending on your particular tax situation, you may be able to capitalize on unique opportunities that help you to lower your taxable income. One such strategy is a Roth conversion, which takes some of all of the funds in a traditional IRA and converts it into a Roth IRA. This strategy can help you to minimize your tax burden and continue to grow your investments in retirement.
Your tax bracket also affects other areas of your financial plan, including your Medicare premiums and the taxes you pay on your Social Security benefits. A robust tax planning strategy can help you to minimize your taxes and keep more of your money working for you.
Minimize taxes, maximize retirement
With proper planning, it’s possible to effectively plan for taxes during retirement. Since different types of retirement income are subject to different tax rules, it’s important to come up with a plan when it comes to taxable retirement income.
Proactive tax planning is an essential part of a successful strategy for minimizing your tax burden in your golden years. If you’re nearing retirement and need help with your financial plan, we’d love to help. Get in touch with us today!