If you’re planning to retire in the near future, or if you already have, you know that minimizing taxes is an important part of creating a successful retirement plan.
You can live on a lot less if you’re not sending a large portion of your money to the Internal Revenue Service (IRS) every year.
For most people, minimizing taxes in retirement does not have to be complicated. Follow these steps to help keep your tax bill low.
Know your tax bracket thresholds.
Before you can make plans for minimizing your tax burden, you first need to know what tax bracket you are in, and where the cutoff points are for tax brackets using your filing status.
A common misconception is that when you reach a higher bracket, all your income is taxed at the higher rate. This is not true. If your income nudges past a bracket threshold, only the income past the threshold is taxed at the higher rate.
For example, say you’re filing status is married filing jointly. You pay 10 percent tax on your first $18,450 of taxable income. Your income between $18,451 and $74,900 is taxed at 15% percent. Income between $74,901 and $151,200 is taxed at 25, percent, and above that the rates rise to 28 percent and as high as 39.6 percent as you reach the higher income brackets.
You’ll see how your tax bracket affects tax planning as you follow the next steps.
Lower your expenses so you can withdraw less from retirement accounts.
To keep your taxes low, you want to stay in lower tax brackets as much as possible. If you keep your expenses down each month, you won’t have to withdraw as much from traditional retirement accounts each year. This generally makes it easier stay in a lower tax bracket.
Because you no longer need to living within commuting distance from work, perhaps the easiest way to lower expenses dramatically is to move someplace where the cost of living is lower – perhaps to a smaller house, or to a location where you can afford to buy a house with cash.
Make a budget, starting with your current spending habits, and see what you can change to lower your annual living expenses.
Consider making tax-exempt investments.
If you are in a high income tax bracket, you may want to consider tax-exempt investments, such as municipal bonds. The rate of return is lower, but your after-tax return may be better than you receive with other investments by the time you figure the tax bite.
If you’re in the low- to mid-income levels, you’re probably better off making investments that pay a better return than trying to avoid taxes altogether.
Prioritize your retirement plan withdrawals.
If you have both Roth retirement plans and traditional IRAs or other plans, you may want to take the majority of your withdrawals from the Roth plans first to avoid bumping your income level into the next bracket.
Be sure to take the minimum distributions from your traditional IRA and other plans, however. After you reach the age of 70 ½, you must take minimum distributions from IRA, SEP IRA, SIMPLE IRA or retirement plan accounts or pay a penalty. You do not have to take minimum distributions from Roth IRAs.
Learn which types of income may have tax advantages.
Not all income is taxed the same. Some types of income have definite tax advantages. For example:
- Capital gains. If you buy investment property, gold or other capital assets and hold them for more than one year, you pay a much lower tax rate on the gain than you would pay on ordinary income. If you’re in the 25 percent tax bracket, the capital gains tax rate is only 15 percent. If you’re in the 15 percent tax bracket, the capital gains rate is 0 percent.
- Gain on the sale of your home. If you sell your home that you have lived in and owned for at least two of the last five years, you may qualify to exclude up to $250,000 of the gain from your income ($500,000 if filing jointly). You can do it again after another two years, if you choose. This may be the best tax-free income, ever.
- Rental real estate investments. If you invest in rental real estate, the net income from the rental is taxable as ordinary income. However, by the time you deduct expenses, including depreciation, you may have little or no rental income to pay tax on. You may even have a tax loss to help offset ordinary income (up to annual limits). That makes real estate rentals a tax-preferred income source for many people.
Watch your timing.
To pay the lowest tax over a period of years, you’ll usually want to keep your income fairly level. If your income is unusually low one year but high the next, you are more likely pay more tax overall.
Plan to sell assets and take retirement plan withdrawals so your income remains somewhat steady from year to year. For example, if you sell capital assets at a loss, consider selling other capital assets that have gone up in value the same year. The losses will help offset your capital gains.
Another example: If you have more income from earnings, assets sales or other taxable income in one year, consider waiting until after December 31 to withdraw more money from your traditional retirement plans. Waiting a few weeks or so could give you considerable savings at tax time.