For most people, paying taxes isn't necessarily a fun thing to do. But fulfilling your obligations to the government can become a bigger burden if you're a senior on a fixed income and you end up with a large tax bill that leaves you struggling.
The good news is, there are steps young people can take throughout their lives to actually reduce their future tax bill in retirement. Here are two of them.
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1. Invest in a Roth account
If you don't want to worry about a tax bill at all, choosing a Roth 401(k) or Roth IRA is the way to go. Both allow you to make tax-free withdrawals as long as you follow certain rules, such as having your account open for at least five years before you begin taking out money and waiting until age 59 1/2 to begin making withdrawals.
The big benefit of Roth IRAs is that you don't need an employer to open one for you. As long as your income isn't too high, you can make contributions to a Roth IRA that you open with a broker of your choosing. However, the good news is that a growing number of employers are also offering access to Roth 401(K) accounts. That means you can take advantage of the higher contribution limits, earn an employer match, and benefit from the ease of having contributions withdrawn from your paycheck.
Of course, there is a price to pay for tax-free withdrawals. Unlike with traditional IRA and 401(k) accounts, you don't get to invest with pre-tax dollars. There's no deduction at all in the year you make contributions to your account. But, deferring the tax savings until you're a senior can make sense if you don't want to worry about owing the IRS money when you're on a fixed income or if you think your tax rate will go up over time.
Another big benefit of Roth accounts is distributions for them don't count in the Social Security test that determines if any of your retirement benefits become taxable. Since a growing number of retirees will find they owe taxes on benefits as the threshold for when the IRS takes a cut isn't indexed to inflation, you could end up very glad you opted for a Roth.
2. Choose where you want to retire carefully
You'll also have to think about where you plan to live if you want the lowest possible tax bill as a retiree. That's because states vary dramatically when it comes to their tax rules.
A total of 37 states don't tax Social Security benefits, while the remaining 13 do. While this is an important consideration, you also need to take into account state tax rules on other income, such as pension and investment funds. And you should think about property taxes and sales taxes as well.
By researching your options for the most tax-friendly states for retirees, you may be able to avoid income taxes altogether while limiting the other taxes you'll pay as well. It's best to start this process early, as the cost of living can vary from place to place, so you'll want to factor in your chosen retirement location as part of a comprehensive plan for the future.
By taking these two steps, you can enjoy a retirement that's largely free of big tax bills and keep more of your hard-earned income to use in your later years.
