One of the bigger mistakes people make in their retirement planning is to fail to consider all of the tax implications of their retirement income. Because retirement income can be generated from a number of different sources, taxation can become somewhat complicated if not downright convoluted.
Although most tax preparation software programs will help you wade through the different tax rules, your greater concern should be the significant amount of money you could lose, unnecessarily, to taxes. You have more control over your taxation during retirement than might know, because you can decide the timing and the amount of your distributions.
By applying some simple tax strategies you will be able to maximize your income. To better understand how these strategies work, a quick review of your retirement income sources is in order:
Retirement Income Sources
Social security benefits > >
Generally, Social Security benefits are received tax free. But, if your other retirement income crosses a certain threshold, a portion of your benefits, up to 85%, become taxable. Earned income and investment income are counted towards the Social Security tax threshold.
Pension income >>
Pension income is fully taxable to the extent that contributions were made on a pre-tax basis. Pension income attributed to after-tax contributions may only be partially taxable.
401k distributions >>
Fully taxable to the extent the contributions were made with pre-tax dollars. Roth 401k distributions are tax exempt because the contributions are made with after-tax dollars.
Roth IRAs >>
Withdrawals are tax exempt if they meet the withdrawal requirements (first withdrawal made five years after first contribution, and after age 59 ½)
Traditional Investment Retirement Account (IRA) distributions >>
Withdrawals are fully taxable. With the exception of the Roth IRA and Roth 401k plans, all defined contribution plans are subject to Required Minimum Distributions which means distributions must begin no later than the first of April after reaching age 70 ½, and must continue in minimum installments based on your life expectancy.
Retirement Tax Saving Strategies
Standard deduction offset >>
In years in which your standard deduction is greater than your taxable income, you can accelerate your distributions that year. In years when your tax rates are low, you should take more income so that it won’t be taxed at higher rates in future years.
Increase tax free income >>
Interest earned from municipal bonds is exempt from federal income taxes.
Annuitize >>
Convert a portion of your assets into an immediate annuity which will create a guaranteed, lifetime stream of income. The annuity income is only partially taxed to the extent that it consists of interest earned. The other portion of annuity payments is a return of capital. Additionally, and maybe even more importantly, annuity income is not considered as part of the Social Security tax threshold.
Delay distributions >>
Try to utilize your tax favored income sources primarily in your early retirement years. Maximize your dividend income, tax free bond income, annuity income before taking taxable withdrawals from your retirement plans.
Be charitable >>
Donate assets such as unwanted cars, computers, cell phones, even frequent flier miles to increase your deductions in years when your income tax rate is higher. Also, if you are in a position to do so, you could consider donating funds from your retirement account to a charity. Those funds are normally taxed at your highest rate and they don’t qualify for basis-step up in your estate, so your tax deduction could be used to reduce your income in years when your tax rate is high.
It goes without saying that retirement tax planning can be somewhat complex. While any one of these strategies could work to reduce your taxes, they should all be reviewed by a qualified tax professional to ensure you receive the maximum tax benefits in compliance with the tax code.
