Understanding the Taxation of Your Retirement Income

As a retiree, taxes can significantly impact your available income, leaving you with less to cover your living expenses. It’s important to recognize that taxes do not cease once you retire, but by taking measures during your working life, you can minimize your IRS obligations in the future.

Understanding the tax rules applicable to retirees is crucial, even for younger Americans, since many decisions to decrease your future tax bill should be made early. This guide provides an explanation of the rules for how common sources of retirement income are taxed and offers some retirement planning tips that can lower your tax obligations.

How to Determine Your Tax Bracket During Retirement Calculating your tax bracket during retirement is similar to determining your tax bracket before retirement, as the same basic tax brackets that apply to all taxpayers apply to retirees as well. Your filing status and taxable income (income minus deductions) determine the bracket you fall into.

Common sources of taxable retirement income include:

• Distributions from traditional 401(k) and IRA accounts
• Investment income
• A portion of your Social Security benefits (in some situations)
• Some pension income
• Income from work (either full time or part time)

Once you have determined your taxable income, refer to a tax bracket table to ascertain your rate based on your filing status.

However, one tricky aspect is that rates can change over time as they are adjusted for inflation or due to tax reform legislation. Therefore, if retirement is a long way off, predicting your future rate can be challenging. Nonetheless, if you can estimate your future retirement income, you can obtain a rough idea of what your tax bracket will likely be, barring any major legislative shifts.

How to Minimize Taxes in Retirement Retirees can take steps to reduce the amount of taxes they must pay. Here are five strategies to consider:

Invest in Roth accounts Withdrawals from Roth 401(k) and Roth IRA accounts are not subject to tax during retirement. If you use these accounts as your primary retirement savings vehicles, or at least put some of your retirement money into them during your working life, you can reduce your future tax bills.

Keep in mind that Roth accounts do not offer an up-front tax break in the year you make contributions. Therefore, choosing Roths over traditional accounts makes sense if you anticipate a higher tax bracket during retirement than when contributing to your retirement accounts.

It is possible to convert traditional accounts to Roth accounts, but this incurs tax consequences, and the five-year rule may limit your ability to access your funds tax-free if you roll over your account too close to retirement.

Reside in a tax-friendly state Some states have more tax-friendly policies than others. Nine states do not levy taxes on any income, while others do not tax Social Security benefits.

As retirement does not limit your geographic location, relocating to a state where you will owe less tax money to the state government can be beneficial.

Strategically plan withdrawals: After reaching the age of 72, mandatory minimum distributions (RMDs) must be taken from certain tax-advantaged retirement accounts like 401(k)s and IRAs, with the amount based on factors such as age and account balance.

However, apart from these rules, individuals largely have control over when and how to withdraw funds. If a year is anticipated to have lower income, larger taxable distributions from accounts during that time could be taken to ensure that the money is taxed at a lower rate.

Opt for tax-free investments: Retirees commonly shift a portion of their retirement assets into bonds to maintain an appropriate risk level as they age. Treasury bonds are generally exempt from taxes at the state and local level, whereas municipal bonds are not taxed at the federal level. It is worth exploring these options to determine if they should be included in the portfolio.

Invest for the long-term: Investment income could be taxed at either short-term capital gains rates or long-term capital gains rates (if the investment is held for at least a year and a day). Long-term capital gains are taxed at a much lower rate than short-term capital gains.

Taxes on Social Security income: Social Security benefits are taxed only on the federal level when provisional income exceeds a specific threshold. Provisional income is half of Social Security benefits, all taxable income, and some non-taxable income such as municipal bond interest.