How to Manage Taxes in Retirement

You’ve planned for vacations, hobbies, and family time in retirement—but have you planned for the IRS? Understanding how your taxes impact your retirement spending is crucial. 

Retirees often ask questions like: Should I convert IRA funds to a Roth IRA, and how will that affect my Medicare premiums? How should I plan withdrawals from my retirement accounts?

This blog will answer these questions and help you navigate the complexities of taxes in retirement.

Understanding Taxes in Retirement

Retirement income comes from various sources, including Social Security, pensions, 401(k)s, IRAs, and taxable investments. Each has unique tax implications, and planning can save you money. Let’s break it down.

Social Security Benefits

While Social Security is often seen as a tax-free safety net, up to 85% of your benefits may be taxable if your income exceeds certain thresholds.

• Income Thresholds for Taxation
• If your combined income (adjusted gross income + nontaxable interest + half of your Social Security benefits) is between $25,000 and $34,000 for single filers -- or $32,000 and $44,000 for married couples--up to 50% of your benefits may be taxable.
• For incomes above these limits, up to 85% of your benefits may be taxable.

By carefully managing withdrawals from other accounts, you can stay below these thresholds and reduce your taxable Social Security benefits.

Pensions and Annuities

Pension income is typically taxed as ordinary income, and state taxes may also apply. For annuities, the tax treatment depends on whether you purchased them with pre-tax or after-tax dollars. Knowing your state's rules is essential, as some states offer exemptions for certain types of retirement income.

401(k) and Traditional IRA Distributions

Withdrawals from traditional retirement accounts are taxed as ordinary income. Additionally, once you turn 73, you must start taking Required Minimum Distributions (RMDs), which could push you into a higher tax bracket. Failing to take RMDs on time results in a hefty penalty—50% of the amount you should have withdrawn.

Roth IRA and Roth 401(k) Distributions

Qualified distributions from Roth accounts are entirely tax-free. To qualify, the account must have been open for at least five years, and you must be 59½ or older. Roth accounts can be a powerful tool for tax planning, as they don't require RMDs.

Taxable Investment Accounts

Dividends, interest, and capital gains from taxable accounts are subject to taxation. While long-term capital gains (investments held for more than a year) are taxed at favorable rates, short-term gains are taxed as ordinary income. Holding investments longer and strategically timing sales can help reduce your tax burden. 

Strategies to Minimize Taxes in Retirement

When it comes to retirement taxes, the goal is to minimize your lifetime tax liability—not just your tax bill for a single year. Here’s how: 

Diversify Your Retirement Accounts

Having a mix of tax-deferred (401(k), traditional IRA), tax-free (Roth IRA), and taxable accounts gives you flexibility to control your taxable income in retirement. This strategy allows you to strategically manage withdrawals to minimize taxes and avoid higher tax brackets in retirement.

Manage Required Minimum Distributions (RMDs)

RMDs can lead to significant tax bills if not planned for in advance. Strategies to reduce RMDs include:

• Qualified Charitable Distributions (QCDs): Directing up to $100,000 annually from your IRA to a qualified charity may satisfy your RMD while excluding the amount from your taxable income. 
• Roth Conversions: By converting some traditional IRA funds to a Roth IRA before RMDs begin, you can reduce the size of your tax-deferred accounts—and therefore lower future RMDs. 

Consider Roth Conversions

Roth conversions involve transferring funds from a traditional IRA to a Roth IRA, paying taxes on the amount converted now rather than later. This strategy works best in years when your income—and therefore your tax rate—is relatively low.

• Impact on Medicare Premiums: Keep in mind that higher taxable income can increase Medicare Part B premiums. For example, converting too much at once could push your modified adjusted gross income (MAGI) above Medicare's income thresholds, resulting in higher premiums for Part B and Part D coverage. This can offset the tax savings of the Roth conversion itself. 

Tax-Efficient Withdrawal Strategies

The sequence in which you withdraw from different accounts matters. A common approach is:

1. Draw from taxable accounts first to take advantage of lower capital gains tax rates.
2. Withdraw from tax-deferred accounts (401(k), traditional IRA) to manage RMDs.
3. Use Roth accounts last, allowing them to grow tax-free for as long as possible.

For example, if your income is low in the early years of retirement, you might prioritize withdrawals from tax-deferred accounts to "fill up" lower tax brackets without triggering higher taxes or Medicare premiums.

Estate Planning and Taxes

Proper estate planning can reduce the tax burden on your heirs. Consider strategies like:

• Designating Roth accounts for inheritance, as distributions are tax-free for beneficiaries.
• Utilizing trusts to minimize estate taxes. 

Key Takeaways:

Managing taxes in retirement requires careful planning and strategy. By understanding the tax implications of your income sources, diversifying your accounts, and employing tax-efficient withdrawal strategies, you can minimize your lifetime tax burden while maximizing your retirement income.

1. Diversify your retirement accounts to provide flexibility in managing taxable income.
2. Plan for RMDs to avoid unexpected tax bills or penalties.
3. Consider Roth conversions to lower future taxes and create tax-free income.
4. Be mindful of how taxable income impacts Medicare premiums.

As you approach retirement, consult with a financial advisor or tax professional on your specific circumstance. Need help with retirement planning? Schedule a no-strings-attached call with us today to learn more. 

This blog article is for informational and educational purposes only. ‍

Sources: Sources:
‍Social Security.gov
IRS.gov
Charles Schwab