You have worked hard for years and saved consistently. You reached retirement with a hard-earned nest egg that you want to last for your golden years. You want to live comfortably and use your funds wisely. One way to increase your disposable income is to reduce taxes paid. Some ways to do that during retirement include:
1. Use Accounts with Different Tax Treatments
There is a plethora of tax favored accounts that can be used to save for retirement. If you have a mix of qualified plans like a 401k and individual retirement accounts (IRAs) with different tax statuses (e.g. Traditional IRA versus Roth IRA), you can withdraw from the accounts that allow tax free distributions first. Withdrawals from a Roth 401k or a Roth IRA are tax free provided you are over 59 1/2 years old and your contributions are over 5 years old. Also Roth IRAs do not require a required minimum distribution after age 70 1/2.
Ensure that you meet the required minimum distribution (RMD) requirement for traditional IRAs and qualified plans if you are over 70 1/2. If you do not take your RMD by the deadline (end of tax year, December 31), the penalty due to the IRS is 50% of the required distribution amount. For example, if you were required to take $5,000 out of your traditional IRA for the prior tax year, you will need to pay the IRS $2,500.
If there are large expenses at year end that require withdrawals that come from traditional IRAs and will place you in higher tax bracket, consider using a credit card or using the IRA tax free rollover option. If you redeposit the distribution amount within 60 days of receipt to the same or a different IRA account, the withdrawal will be tax free. The tax free rollover option is only available once a year.
Consider taking distributions out of your taxable investment accounts first. Consult with your investment professional and accountant to ensure that your liquidation strategy minimizes short term gains, which are taxed at ordinary income rates. When possible, sell investments that have a loss to reduce taxes paid on distribution. Take advantage of investments with qualified dividends and long term capital gains, which are taxed at lower rates with a maximum of 20% versus the highest income tax bracket of 39.6%.
2. Consider Tax Efficient Vehicles
Take advantage of investment vehicles like municipal bonds, which offer interest income free of federal income taxes and in some cases free of state income tax. Consider using common stocks which generate dividends taxed at the lower qualified dividend rate and gains are only taxed when the stock is sold. If you do not have the time or inclination to choose individual common stocks, consider using an index exchange traded fund (ETF). Because index ETF managers trade less frequently, the fund generates lower capital gains which results in a lower tax liability for the investor. Dividends paid by ETFs are often qualified, which also reduces taxes paid. Like a common stock, capital appreciation in an ETF is only taxed when the investment is sold.
3. Reduce Expenses
If possible, pay off your mortgage before retiring. This payment is probably the largest monthly expense and not having to use taxable funds to cover it will reduce taxes due. Also be mindful of variable expenses which also need to be paid with retirement account withdrawals taxed as income. In general reducing expenses reduces account distributions considered as income lowering your tax bracket. Finally. consider living in a state without state income taxes like Texas or Florida. State income tax rates can be as high as 10%.
By Andre Bradley