5 Ways to Cut Your Tax Bill in Retirement
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5 Ways to Cut Your Tax Bill in Retirement


Retirement is supposed to be your time to sit back, relax and enjoy spending the money you’ve spent decades earning and saving. Unfortunately, just because you’re not taking home a paycheck anymore doesn’t mean that Uncle Sam doesn’t want his cut of your income.

Many soon-to-be retirees don’t realize how big a bite taxes can take out of their nest eggs, even if they’re not paying Social Security or Medicare taxes. Ultimately, when you’re figuring out how much money you have for retirement, what really matters is how much you can actually spend.

Fortunately, some smart planning before retirement and a few strategic money moves in retirement can drastically reduce your IRS bill each year. “If you make a long-range tax plan, you can make adjustments as you go,” says Phil DeMuth, author of The Over-Taxed Investor. “If you don’t have a plan, you’ll end up getting whacked by high taxes you’re not expecting.”

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Here are five tips for saving on taxes in retirement.

Before you retire:

1. Consider a Roth. In addition to putting pre-tax money in a 401(k) or an IRA, which grows tax-free until retirement, consider setting aside some retirement savings in a Roth account. In Roth accounts, you’ll have to pay taxes now on contributions, but the money grows tax-free and there are not taxes on qualified withdrawals. To qualify for a Roth IRA, you must earn less than $131,000 or $193,000 for married couples, but if your company offers a Roth 401(k), there are no income limits.

While Roth accounts are a no-brainer for anyone who thinks that they’re in a lower tax bracket now than they will be in retirement, putting some money into a Roth may make sense for even those high earners (see below). Having money in both types of accounts, as well as a taxable brokerage account, will give you more flexibility when it comes to making withdrawals.

2. Treat your health savings account as a retirement account. If you have a high-deductible health insurance plan, as a growing number of Americans do, then you are able to put money into a health savings account. HSA accounts get triple tax benefits: Money goes in before taxes, grows tax-free, and withdrawals aren’t taxed as long as they’re used for qualified health expenses. While you may need to tap this account for current expenses, saving as much as possible will give you a tax-free source of funds for out-of-pocket medical expenses in retirement, which total nearly $250,000 for the average retiree.

3. Think asset location. While you probably already practice asset allocation, ensuring that you have the appropriate mix of stocks and bonds throughout your portfolio given your risk and time profile, you also need to think about “asset location,” says Philip Lee, a certified financial planner with Financially In Tune in Wakefield, Mass. That means putting tax-inefficient securities like REITs, alternative investments and taxable bonds into qualified plans and IRAs, and tax efficient assets like index funds and municipal bonds in taxable accounts. Roths are a good place for your most aggressive investments, Lee says.

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After you retire:

4. Plan your retirement withdrawals with taxes in mind. You can start taking money out of tax-deferred accounts at age 59 ½, and at age 70 ½ you’ll need to start making required minimum distributions from tax-deferred accounts and paying taxes on them. Failing to make the required minimum withdrawal (which is calculated based on your life expectancy and account balance) results in a penalty of 50 percent of the amount you failed to withdrawal.

However, taking the minimum withdrawal might push you into a higher tax bracket. Minimize what you owe by making withdrawals from tax-deferred accounts early in retirement when you’re in a lower bracket. Put the withdrawals into either a taxable savings account or brokerage account or convert them into a Roth. You’ll have to pay taxes now on the money you convert, but you’ll have lower minimum distributions and pay fewer taxes in the long run.

“You have to think not only about your taxes this year, but also about your taxes every year for the rest of your life,” says David Richmond, President of Richmond Brothers in Jackson, Mich.

For example, a 54-year-old who has $500,000 saved for retirement in an IRA who starts making annual $40,000 conversions at age 55 would pay more than $300,000 less in taxes by age 95, according to an analysis by T.Rowe Price. Beginning the conversions at age 65 would still save you nearly $40,000 in taxes. The rules around Roth IRA conversions are complicated, so consult with a CPA or financial planner before undertaking this strategy.

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Consider your Roth account, which you can withdraw from without paying taxes and has no minimum distribution rules, a contingency fund. You can tap into it without pushing yourself into a higher tax bracket if unexpected costs crop up throughout the year, or if the stock market dives and you don’t want to pull out investments from other accounts. If you don’t need that money, you can let it continue growing tax-free until you do, or you can pass it to your heirs as part of your estate and they can take tax-free withdrawals from it as needed.

5. Move somewhere with favorable retiree tax laws. While you’ll owe federal taxes on retirement income no matter what, the rules vary widely by state. Five states (Florida, Alaska, Wyoming, Nevada and South Dakota) have no income tax at all, and others give generous breaks to income from retirement accounts, Social Security and pensions. Of course, while low taxes are important, they’re not the only factor in a successful retirement. Even if you don’t move states, moving to another municipality can cut your property taxes, which can weigh heavier on retirees because of their fixed income.

Any move in retirement will require more than just a financial analysis. You’ll also want to evaluate a region’s cost of living and health care offerings, as well as whether you’ll have a supportive network of family and friends nearby.