How to Pay Less Taxes in Retirement

May 22, 2013

Last week, we talked about how various sources of retirement income are taxed. Here are some strategies you can use to minimize those taxes:

Strategy #1 – Reallocating your investments

Maintaining income-producing assets like corporate bonds and REITS in taxable accounts will only add to your taxable income each year, so consider reallocating your portfolio such that ordinary income investments are held in tax-deferred or Roth accounts, while capital gain investments, like stocks, and tax-free investments, like municipal bonds, are held in taxable accounts. For example, let’s say you have a $500k portfolio with $250k in a taxable brokerage account and $250k in a tax-deferred or tax-free IRA.  If your goal is to have 50% in stocks and 50% in bonds, it would be wise to keep the stocks in the brokerage account and the bonds in the IRA.

Strategy #2 – Spending down your taxable accounts first

In some instances, spending down a taxable account will allow a retiree to defer collecting pension and Social Security benefits, while reducing the amount of assets that are taxed every year. While it’s true the higher pension and Social Security benefits will generate more taxable income in the future, having to pay 35 cents in tax on an extra $1 is still a 65 cent net gain. Spending down taxable accounts first also defers distributions from tax-deferred and Roth accounts, giving them more time to grow.

Strategy #3 – Using Roth accounts to avoid higher tax brackets

As mentioned earlier, retired taxpayers are subject to the same tiered income tax brackets as working taxpayers, so knowing when to tap into Roth assets can keep a taxpayer from entering a higher marginal tax bracket.  Consider the following example:

Let’s say a retired couple, both over age 65, has $100k in gross income that consists of $30k in Social Security, $18k in pension benefits, $2k in taxable interest, and $50k in traditional IRA distributions.  Using this tax estimator, the marginal tax rate for this couple would be 25%. If instead this couple took $40k in traditional IRA distributions and $10k in Roth distributions, their marginal tax rate drops to 15%

Which strategy, if any, works for you will depend on your individual circumstances, but it’s important that you are at least familiar with them.  If it all seems too confusing, you may want to work with a tax planning professional.  They can help you deploy the strategy that makes the most sense for you.

To learn more, see Erik Carter’s article titled How to Minimize Taxes On Your Retirement Income.