3 Strategies for Retirees to Lower Their Tax Bills

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  • Tax planning can help boost your retirement savings and help you avoid paying unnecessary taxes.
  • Understanding how your retirement income is taxed can help you increase your returns without increasing your risk.
  • The order in which you take your retirement income as well as how much you withdraw can help you from paying more taxes over the long run.

You should never pay more than you have to.

The next tax year may seem a long ways away, but the decisions you make now can impact the taxes you have to pay. To minimize taxes in retirement, here are three tax strategies that can help you keep more of your hard-earned money. 

1. Understand how taxes work

Most retirees own two pots of money. One is the money that has already been taxed (let's call it "regular money"). Two is the money that has not been taxed. We'll call this "retirement money," and it could include an IRA, 401(k), 403(b), etc. When you spend $1 of regular money, the cost to you is exactly $1. When you spend $1 of retirement money, the cost to you could be as much as $1.59 (depending on your tax bracket) because you may have to pay income taxes on the amount you withdraw.

Not all investments have the same tax impact either. Short-term capital gains are taxed as ordinary income and long-term capital gains are taxed much lower. Tax-inefficient investments such as bonds, REITs, tax-exempt bonds, and actively managed funds should go in tax-deferred accounts. Tax-efficient investments such as index funds and ETFs should be put in taxable accounts. This strategy can help minimize taxes and boost your investment returns without increasing risk, especially if you are in a high tax bracket. You can maximize your tax savings by holding certain investments in the appropriate types of accounts.

2. Prioritize retirement account withdrawals

The order in which you draw your assets can make a big impact on your taxes. Let's say you have $100,000 in a taxable account and $100,000 in a tax-deferred retirement account like an IRA. Let's assume the money in each account earns 6% per year and you take $6,000 a year in withdrawals for 20 years. 

If you took withdrawals from the taxable account first, you would have $150,000 more at the end of the 20 years than taking money from the retirement money first. By spending your "regular money" first, you can take advantage of the tax-deferral benefits associated with IRAs and qualified retirement plans. You should tap your taxable accounts first, then your 401(k) or IRA, and your Roth IRA last. Withdrawing your retirement funds in a tax-efficient manner can lead to a lower tax bill over the long run.

3. Reduce withdrawals to optimize your tax bracket

The lower your income, the lower your tax bracket. If you are able to keep your spending down, you will not have to withdraw as much money from your retirement accounts. This may help you reduce your taxes since withdrawals from retirement accounts like traditional IRAs and 401(k)s are considered income. 

The IRS has updated the 2022 taxable limits for the different tax brackets. The income limit for the 12% tax bracket is $41,775 ($83,550 for married couples filing jointly). The next tax bracket almost doubles to 22% if your income is $41,775 to $89,075 ($83,550 to $178,150 for married couples). The next set of tax brackets are 24%, 32%, 35%, and 37% based on your income. 

If you are aware of the different tax thresholds and able to control your spending, you can focus on being in a lower tax bracket. If you are on track to withdraw $45,000 this year, by adjusting your spending and reducing your withdrawals by $300 a month, you can lower your tax threshold from 22% to 12%. 

Making smart tax decisions can have a big impact on the amount of money you have in retirement. Understanding the different tax thresholds and withdrawing retirement funds in a tax-efficient manner can help boost your retirement savings. 

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