You don’t have as much income coming in during retirement as you did during your working years. That means you need to maximize every dollar even more than when you were working. Here are three strategies to reduce your tax burden in retirement.
In retirement, you’re likely to have at least the following four kinds of income:
Strategy 1: Formulate Your Pre-Tax and Post-Tax Distributions
In retirement you’re likely to have at least the following four kinds of income.
| Income Type | Taxability |
|---|---|
| Social security | Depends on amount of other income |
| Pension | Generally taxable in the year of distribution |
| Distributions from pre-tax accounts | Taxable in year of distribution |
| Distributions from post-tax accounts | Non-taxable |
TaxabilityDepends on amount of other income
TaxabilityGenerally taxable in the year of distribution
TaxabilityTaxable in year of distribution
TaxabilityNon-taxable
The first two sources in the table above are fixed. Although you have control over when you start collecting these benefits, you’re getting these payments every month once they start.
However, subject to required minimum distribution (RMD) rules, particularly for pre-tax accounts, you control your income for the year from your pre-tax accounts, such as traditional IRAs, and from your post-tax accounts, such as Roth IRAs.
The goal, then, is to take distributions from these retirement accounts in such a way that:
- provides you with enough cash to sustain your lifestyle in retirement after taking into account your fixed income sources,
- minimizes your tax liability, and
- preserves tax-free growth as much as possible.
And thanks to ever-increasing standard deduction amounts — currently over $30,000 for married couples over the age of 64 who file jointly — you could possibly withdraw money from your pre-tax accounts and still end up with no federal tax liability.
In light of this, a common basic strategy is to:
- Determine how much total income you need annually in retirement,
- Subtract your annual fixed income sources, such as pension and Social Security income,
- Withdraw from your pre-tax accounts up to the amount that would trigger no or little tax liability (subject to the RMD rules).
- Make up the difference, if any, with distributions from post-tax accounts.
Utilizing a strategy like this that involves taking as much “taxable” distributions as possible from pre-tax accounts while still minimizing your tax liability preserves capital in your post-tax accounts to grow tax-free.
Also, if you haven’t yet reached the age at which you need to start taking RMDs, accelerating the withdrawal from your pre-tax accounts — while still being mindful of current taxes — will minimize the amount of RMDs the government will require you to take every year in the future.
Strategy 2: Move to a Low- or No-Tax State
Obviously, if you move from a state with a high-income tax burden to a state with a low-income tax burden, you’ll likely pay less in state income taxes.
That said, the savings may not be as much as you think, so be sure to run the numbers before making any rash moves. Unless you have significant taxable income in your state every year in retirement, moving to another state to save on taxes may not be as much of a boon as you might think.
Let’s take the example of a married retired couple in their mid-60s living in California, a high-tax state.
Combined, they collect $35,000 in Social Security income per year. One spouse has a pension from an old employer that pays $5,000 monthly, so $60,000 yearly. They also withdraw $25,000 annually from Roth accounts. Before considering taxes, their annual retirement income is $120,000.
They have some acquaintances who moved to Texas, which does not impose a personal income tax, to save on taxes. This couple is considering doing the same. But what’s their actual state tax burden? Current California tax rates are less than $300 per year.
Frankly, it would take years of saving $300 per year in state income taxes before this couple even recoup the costs of moving to Texas. Not to mention the personal cost of moving far away from their children, grandchildren, and others they’re close to.
Also, be sure to consider your overall tax burden. It’s common for states that don’t impose a personal income tax to impose higher-than-average property or sales taxes.
Strategy 3: Leverage Your Real Estate
If you’ve invested in real estate throughout your working years, you’re likely aware of the tax benefits that come with owning property.
For example, if you have rental properties, you’ve enjoyed depreciation deductions that have likely significantly reduced your income tax burden on your rental cash flow over the years.
But depreciation doesn’t last forever. Residential properties are depreciated over 27.5 years, and commercial properties are depreciated over 39 years.
So if you acquired investment property decades ago, make sure you understand in what year each property’s depreciable life is exhausted because you may have a sharp uptick in taxable income in that year. Consider this increase in taxable income at some point in the future when planning your pre-tax vs. post-tax withdrawals.
Also, suppose you sell a depreciated property to help fund your retirement. In that case, all that historical depreciation will increase your gain on sale and may be taxed at a higher tax rate than typical capital gains. This is known as depreciation recapture.
Of course, depreciation recapture and other gains on the sale of investment property can be postponed by utilizing a 1031 exchange. Still, you’d have to reinvest the proceeds into a new real estate investment that qualifies as a 1031 exchange replacement property.
Another real estate tax trap concerns your primary residence rather than rental properties. Suppose you’ve lived in your home for several decades. In that case, you may be sitting on significantly more unrealized gain than the home sale gain exclusion limits of $250,000 for single taxpayers and $500,000 for married taxpayers filing jointly.
If you choose to sell your house, one way to mitigate any excess gain is by reviewing your home records and adding up the cost of any capital improvements you made to your home over the years since these costs will reduce your taxable gain. And, of course, any selling expenses on the sale — such as real estate broker’s commissions as well as some closing costs — would reduce your gain on sale as well.
This article is intended for general informational and educational purposes only, and should not be construed as financial or tax advice. For more information about whether a reverse mortgage may be right for you, you should consult an independent financial advisor. For tax advice, please consult a tax professional.
