Planning for retirement involves more than just saving money—you need to understand how taxes will impact those savings. The amount of taxes you pay on your income can significantly affect your retirement income; how much money you will have to live on and how long your savings will last.
Whether you're just starting to save for retirement or are nearing retirement age, this guide will help you understand how to manage your retirement income in a tax-efficient manner, so you can make the most out of your hard-earned savings.
Overview of the 3 tax buckets & their impact on retirement
All income, including your retirement income, can be put into one of three tax buckets. Each has different implications about when you pay the taxes owed on the dollars you've earned, whether that income is from a job or investment interest and gains.
1. Taxable income ('Tax now')
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These kinds of accounts are funded with dollars you pay taxes on. Then you pay additional taxes as interest, dividends and
2. Tax-deferred income ('Tax later')
The
Pensions. Annuities. Retirement accounts like traditional IRAs, 401(k)s, 403(b)s & 457(b)s.
The tax advantage is that you don't pay income tax on the money when you contribute it, and you instead pay when you make withdrawals—ideally waiting to do so until retirement so you don't face early withdrawal penalties. Saving for retirement in tax-deferred accounts can help reduce your taxable income, keeping you in a lower tax bracket during your working years and allowing your investments to grow tax-deferred until you withdraw them.
3. Tax-free income ('Tax never')
You pay taxes on your contributions and purchases to fund these savings and investment tools at the start, but you'll avoid tax on the principal and any growth when you withdraw it—as long as you meet certain conditions. Saving for retirement in nontaxable accounts won't lower your tax liability in your working years, but the tax efficiency plays out in your retirement when you can access tax-free income.
Working income tax diversification into your retirement plan
You've probably heard of portfolio diversification, or spreading your investments across a mix of different assets or securities to reduce risk.
Many people assume they'll be in a lower tax bracket in retirement, but that's not always the case. You may have fewer deductions in retirement—especially if you've paid off your mortgage and no longer have children to claim as dependents.
Tax diversification can help you balance your income sources, stay in a lower tax bracket and take advantage of tax credits and deductions.
Tax refresher: Credits, deductions & brackets
Taking advantage of
Tax credits & how they work
Some common tax credits include:
Child and dependent care credit. - Earned income tax credit.
- Education credits, including the lifetime learning credit and the
American Opportunity Tax Credit. Saver's credit. - Credit for the elderly or disabled.
Tax deductions & how they work
Common deductions include:
- IRA contributions.
- Pre-tax contributions to a 401(k), 403(b) and most 457(b)s.
- Health savings account (HSA) contributions.
- Charitable donations.
- State and local taxes.
- Mortgage interest.
- Business expenses.
- Medical expenses.
- Additional standard deduction for seniors 65 and older.
How tax brackets come into play
The
2024 tax brackets for single filers
There are
- 10% for taxable incomes of $11,600 or less
- 12% for taxable incomes $11,601 to $47,150
- 22% for taxable incomes $47,151 to $100,525
- 24% for taxable incomes $100,526 to $191,950
- 32% for taxable incomes $191,951 to $243,725
- 35% for taxable incomes $243,726 to $609,350
- 37% for taxable incomes $609,351 or greater
2024 tax brackets for married couple filing jointly
- 10% for taxable incomes $23,200 or less
- 12% for taxable incomes $23,201 to $94,300
- 22% for taxable incomes $94,301 to $201,050
- 24% for taxable incomes $201,051 to $383,900
- 32% for taxable incomes $383,901 to $487,450
- 35% for taxable incomes $487,451 to $731,200
- 37% for taxable incomes $731,201 or greater
How life changes can impact your income tax calculations
Significant life changes in retirement, such as the
When a spouse dies, the surviving spouse can file married, jointly in the year of their death (unless they remarry). However, after that year, the surviving spouse becomes a single filer, which means they may move into a higher tax bracket and lose the higher standard deduction available to joint filers.
State taxes also can affect your retirement income. Some states have no income tax, some don't tax Social Security and pension income, and others tax retirement income at varying rates. Consider the state you live in (or plan to retire in), as it can have a substantial effect on your overall tax burden.
Consulting with a tax professional can help you understand how these changes impact your taxes as you work toward a financially stable retirement.
Understanding how retirement accounts & income are taxed
When you retire and start depending on your savings, investments and benefits to support you and your loved ones, it's crucial to know how these new income sources will be taxed. For instance, taxes automatically are withheld from some retirement income sources but not from others.
Here's a look at how common retirement accounts and income sources are taxed.
Social Security benefits may be taxed
Depending on your total income, up to 85% of your Social Security benefits may be subject to federal income tax.
The exact percentage depends on your combined income. This is the sum of half the Social Security benefits you received during the tax year plus other income earned, such as pensions, wages, dividends, interest (including tax-free bond interest) and capital gains.
You can choose to have federal taxes withheld from your Social Security benefits at a rate of 7%, 10%, 12% or 22%.
Traditional IRAs & 401(k)s are taxed upon withdrawal
Traditional IRAs, 401(k)s and other qualified retirement accounts are tax-deferred. Contributions typically are deductible from your income in the year they were made, while withdrawals are taxed as ordinary income in the year they're taken.
With these accounts, you have to start taking
If you were born:
- 1950 or earlier: RMDs start at age 72.
- Between 1951 and 1959: RMDs start at age 73.
- 1960 or later: RMDs start at age 75.
Taxes generally aren't automatically withheld from IRA distributions unless you request it, but many 401(k) plans require a mandatory 20% federal tax withholding on all distributions.
Explore the ins & outs of traditional accounts
Pension & annuity income taxation
When you purchase a
The tax treatment of your payouts depends on whether you have a
Income tax is generally withheld from pension and annuity withdrawals. You can adjust the withholding amount based on your estimated tax liability.
Investment accounts are taxable
Interest, dividends and capital gains from nonretirement
Short-term capital gains (from assets held one year or less) are taxed at your ordinary income tax rate.
You can lower your capital gains taxes by timing your sales right to take advantage of lower long-term
Tax-free ('tax-never') retirement income sources
Tax-free retirement income sources allow you to withdraw funds without paying income taxes. Here are some common tax-never retirement income sources:
Roth IRAs
Roth IRAs also don't have RMDs during the account holder's lifetime, allowing your investments to grow for as long as you want.
However, Roth IRAs aren't available to everyone. If your modified adjusted gross income (MAGI) is above a certain threshold, your ability to contribute to a Roth IRA may be limited or eliminated.1 If this applies to you, check out
Roth 401(k)s & other Roth retirement plans
One benefit of a Roth 401(k) is there's no income limit to participate. However, if your employer matches contributions to your plan, it's essential to recognize that those matching contributions are made to a traditional 401(k) account—they'll be subject to taxes upon withdrawal.
Municipal bonds
Interest income from municipal bonds is generally exempt from federal income tax. If you buy bonds issued by your home state, the interest also may be exempt from state income taxes.
While the interest is tax-exempt, any capital gains from selling municipal bonds are taxable.
Permanent life insurance
The
Health savings accounts (HSAs) for retirement
- Contributions: Contributions to an HSA are tax-deductible or pre-tax if made through payroll deductions.
- Earnings: The funds in the HSA grow tax-free.
- Withdrawals: Withdrawals for qualified medical expenses are always nontaxable. After age 65, withdrawals for nonmedical expenses are subject to ordinary income tax rates, but you won't have to pay the 20% penalty for taking a nonqualified withdrawal.
You also can use an
Incorporating HSA savings into your retirement plan can supplement your retirement income without increasing your tax bill.
Are you withholding enough tax from your retirement income?
While you may withhold taxes from some sources of retirement income, it might not be enough to cover your actual tax liability.
Here are some tips to help you account for the gap:
- Estimate your total taxable income: Calculate your expected taxable income from all sources, including Social Security benefits, retirement accounts and investments.
- Determine your tax bracket: Based on your total estimated income, determine your federal and state tax brackets to get an idea of your overall tax liability.
- Adjust withholding or make estimated payments: Adjust the withholding on your Social Security, pension and other income sources as needed. If withholding isn't enough, make quarterly estimated tax payments to avoid penalties and interest.
- Consult a tax professional: Work with a tax advisor to review your retirement income plan and ensure you meet your tax obligations efficiently.
3 strategies to minimize taxes in retirement
Keeping your taxable income as low as possible in retirement requires careful planning and strategic moves. Any significant increase in your income can push you into a higher tax bracket, potentially affecting your Social Security retirement benefits and Medicare premiums.
Here are key strategies to help you stay in a lower tax bracket.
1. Continue to maximize your retirement contributions
Maximizing your retirement contributions will reduce your taxable income now.
Contributions to traditional IRAs and 401(k)s are generally tax-deductible, lowering your taxable income—which is particularly beneficial if you're still working and earning income.
If you are 50 or older, don't forget about additional
2. Make tax-efficient withdrawal decisions
Once you start taking withdrawals in retirement, the goal is to draw from your different income buckets in a way that keeps you in the lowest tax bracket possible.
Retirement withdrawal strategies : If your taxable income is high in a given tax year—for example, if you sold a big investment—you may want to pull more from a "tax-never" account. If your taxable income is low, this can be a good opportunity to make a Roth conversion or take more from taxable or tax-deferred accounts.
The 4% rule: This popular rule of thumb suggests withdrawing no more than 4% of your total investment assets starting the first year of retirement. While guidelines can be helpful, it's essential to consider your unique financial situation and adjust as necessary.
Systematic withdrawal plans: A systematic withdrawal plan is a structure of tapping into your retirement funds periodically to provide a predictable cash flow.
The right retirement withdrawal strategy for you depends on several factors, including your income needs, tax situation and the different tax treatments of your accounts. It's important to work with an advisor who can help you time withdrawals to your advantage.
3. Strategically shift assets to tax-free accounts
Moving assets from tax-deferred to tax-free accounts can reduce your taxable income and keep you in a lower tax bracket in retirement.
Roth conversions
Consider
RMD window of opportunity
Medicare premiums
Your income impacts how much you'll have to pay for Medicare. Higher income increases your Medicare Part B and Part D premiums. Roth conversions and other strategic moves at least two years prior to filing can help manage your modified adjusted gross income and lower premiums.
Taxes on Social Security income
Holistic planning is essential to bring all these pieces together. Working with a financial advisor can help you develop a comprehensive strategy covering all aspects of your retirement income and tax situation.
Considerations for tax-efficient charitable giving in retirement
Charitable giving can be a powerful tool for reducing your tax burden while supporting causes you care about. By strategically planning your donations, you can maximize tax benefits while making a significant impact. Here are some tools and strategies to help you give efficiently.
Qualified charitable distributions
Charitable bunching/bundling
Many people fail to benefit from their charitable deductions because they don't itemize—their itemized deductions aren't more than the standard deduction available for their filing status.
Charitable bunching, or bundling, involves combining multiple years of charitable contributions into one tax year to overcome the barrier to itemizing.
For example, if you usually donate $5,000 annually to your local food bank, you could donate $15,000 every three years instead. That $15,000 donation, combined with other itemized deductions like mortgage interest, state/local taxes and out-of-pocket medical expenses may give you a greater tax benefit than claiming the standard deduction.
Donor-advised funds
DAFs allow you to decide which charities to support and when to make donations, allowing for strategic tax planning.
Charitable gift annuity
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This can be a beneficial way to support your favorite charity while maintaining the financial security of receiving fixed-income payments for life. The donation provides a partial tax deduction at the time of the gift, and a portion of each annuity payment may be tax-free.
Charitable remainder trusts
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The benefits include:
- You or your beneficiaries can receive income from the trust for a set number of years or for life.
- You receive a partial tax deduction based on the present value of the remainder interest that will eventually go to charity, and the trust can sell appreciated assets without immediate capital gains tax.
Your financial advisor can help you choose the most tax-efficient charitable giving strategy for your financial circumstances and philanthropic goals.
Get more tips on tax-wise charitable giving
Setting up your wealth transfers to be more tax-efficient
Many retirees hope to
Minimize estate taxes
The good news is that you can minimize the impact of estate taxes with thoughtful
- Use the estate tax exemption. The federal estate tax only applies to estates worth more than an
inflation-adjusted amount. Proper planning can help ensure you make the most of this exemption, potentially doubling the exemption amount for married couples through portability.
- Give during your lifetime. You can give gifts up to the
annual gift tax exemption to children, grandchildren and other loved ones each year without paying gift taxes or cutting into your lifetime exemption amount. This can significantly reduce the size of your taxable estate over time.
- Create an irrevocable trust. Placing assets in an
irrevocable trust removes them from your taxable estate. Trusts also can provide asset protection and control over how and when your beneficiaries receive their inheritance.
Keep gift & inheritance taxes in mind
You may want to make larger gifts to your loved ones than allowed under the annual gift tax exemption limit. In that case, you either can pay the gift tax on those gifts or allow them to reduce your lifetime estate tax exemption.
Any estate planning strategy also should take inheritance taxes into account. While the federal government doesn't impose an inheritance tax, some states do. The tax rate and exemption amounts vary by state, so it's essential to understand the rules in your state if you are leaving any bequests for your heirs.
Consulting with your estate planning attorney and financial advisor can help you identify the right estate planning strategies for your specific situation and goals.
Get expert help with a balanced approach to retirement taxes
Planning for taxes in retirement is crucial to ensuring financial security and maximizing the value of your savings. By understanding the types of retirement income, using tax-efficient strategies, and leveraging charitable giving and wealth transfer techniques, you can reduce your tax burden and enjoy a more secure retirement.