You've worked hard throughout your career to save for retirement so, of course, you want to make the most of your money. But when planning for retirement, many people don't consider how taxes will affect their savings.
If you're saving in a 401(k) or traditional IRA, your dollars are tax-deductible up front. But you will need to pay income tax on the withdrawals once you retire. If you're already going to be stretched thin financially during retirement, giving a good chunk of your savings to Uncle Sam may make your golden years even more challenging.
Fortunately, by making a few smart and strategic decisions, there are a few ways to save on taxes in retirement.
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1. Understand your tax bracket
Exactly how much income tax you pay on your retirement account distributions will depend on what tax bracket you fall under. By making withdrawals strategically from your 401(k) or traditional IRA, you can ensure you're not paying more than you have to in taxes.
| Tax Rate | For Unmarried Individuals, Taxable Income Over: | For Married Couples Filing Jointly, Taxable Income Over: |
|---|---|---|
| 10% | $0 | $0 |
| 12% | $9,700 | $19,400 |
| 22% | $39,475 | $78,950 |
| 24% | $84,200 | $168,400 |
| 32% | $160,725 | $321,450 |
| 35% | $204,100 | $408,200 |
| 37% | $510,300 | $612,350 |
Data source: IRS.
So, for instance, say you're married, and the two of you expect to need around $80,000 per year in retirement. If you withdraw exactly $80,000 from your retirement account, you'd fall into a higher tax bracket than if you could make ends meet on just $78,950 or less per year.
Keep in mind, too, that these brackets account for all taxable retirement income -- which can include Social Security benefits. Exactly how much you'll pay in taxes on your Social Security benefits depends on a variety of factors, but the bottom line is that your additional retirement income can potentially push you into a higher tax bracket. By taking all other sources of retirement income into consideration, aim to withdraw your retirement savings accordingly so you can stay within your ideal tax bracket.
2. Invest in a Roth IRA
All types of retirement accounts have their advantages and disadvantages, and one of the main perks of investing in a Roth IRA is that you can withdraw your money tax-free in retirement. Because your contributions are taxed up front when you put money into the account, you don't owe any taxes once you make withdrawals.
A Roth IRA is especially helpful if you're going to be stretching every dollar in retirement, because the money in your account is the amount you'll actually be able to spend. In other words, what you see is what you get. Although you won't get the up-front tax break when you make the initial contributions like you would with a 401(k) or traditional IRA, you will be saving money when you need it the most during retirement.
Another advantage of the Roth IRA is that you don't need to start taking required minimum distributions (RMDs). With a traditional IRA or 401(k), once you turn age 70 1/2, you'll need to start withdrawing money from your account whether you want to or not (because you haven't paid taxes on this money yet, and the government wants its share eventually). This can be problematic if you plan to continue working past that age, because you may want to keep your money in your retirement fund until you actually need it so that it can continue growing for as long as possible. With a Roth IRA, there are no RMDs, so you can keep all the money in your account for the rest of your life if you choose.
If you've decided that a Roth IRA is the right move for you, it is possible to convert a traditional IRA into a Roth IRA -- but be sure to weigh the pros and cons first. Once you convert to a Roth IRA, you can't change your mind and undo the decision, so make sure it's a smart move before you pull the trigger.
3. Consider moving to a more tax-friendly state
Sometimes, the place you call home can provide a tax break simply by living there. There are seven states in the U.S. that don't have state income taxes: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming.
Also, New Hampshire and Tennessee don't tax your earnings or other forms of income -- just income from dividends and interest. So, if you're living in any of these nine states, you may not have to pay much (or anything) in state income taxes.
Keep in mind, however, that you'll still need to pay federal income taxes on distributions from your 401(k) or traditional IRA, so can't avoid taxes altogether. But depending on how much you're earning in retirement income and what your savings look like, saving a few thousand dollars per year on state income tax could help considerably.
Before you pack up and move, consider all the financial advantages and disadvantages of moving to a new state. You may save a considerable amount of money on taxes each year, but if housing prices and the general cost of living are higher, you may not come out ahead financially. That said, if you do your research and decide you can save money by moving to a more tax-friendly area, you may be able to live a much more comfortable and enjoyable retirement.
To some degree, taxes will always be unavoidable. But that doesn't mean you can't be strategic about your retirement decisions to save money. By considering how taxes will affect your retirement income and adjusting your retirement plans accordingly, you can save money and make the most of every penny.
