What You Should Know About Retirement Income and Taxes.

You’ve figured out your budget, your retirement nest egg is substantial, and you’re ready to make the transition to living on what you’ve accumulated in savings instead of income you make from work. But have you thought through the tax implications of that transition?

It’s very common for tax planning to be overlooked when moving from your working years to your retirement years. A lot of times you’re under the assumption that you’ll be in a lower tax bracket and that your Social Security payments won’t be fully taxed. In fact, a recent study found that 57% of Americans rarely consider the taxes they will pay/are paying in retirement.1 Although this can be an expensive mistake and it may have implications for other retirement benefits, there are things you can do to better prepare.

A New Tax Landscape

Depending on your income from all other sources (like dividends, retirement account withdrawals, required minimum distributions, rental income, business income, etc.), up to 85% of your Social Security benefits may incur Federal income taxes. Additionally, withdrawals from a 401(k) and traditional IRAs are taxable, since the money you funded them with was tax deferred. Pension payments are also considered taxable income. If you have taxable investment accounts, dividends, interest income and capital gains from stock and bond sales will all create tax liabilities as well.

Your new retirement tax bracket is derived from your combined income, which is your adjustable gross income, nontaxable interest income and some portion of your Social Security. Medicare premiums are based off of a two-year look-back where your income dictates the amount you’ll need to pay for your Medicare Part B. If last year your reported income goes up high enough, your premiums for Medicare Part B will go up the following year. I’ve seen cases like this where the difference of a few dollars less in income would have saved the couple hundreds to thousands of dollars over the course of the year.

Lifestyle Tactics to Lower Your Tax Bill

The first step to reducing your potential tax bill is to get your income needs lower – for this reason, many people try to pay off or pay down as much as possible on mortgage and other debts before retirement. This means you won’t have to withdraw as much income, which will lower your tax liability. This may require some reorganizing of budgets or putting off discretionary expenses during the last years of working, but the advantage of doing things this way before you retire may be worth it.

If you’re planning to move geographically in retirement, or even if you hadn’t thought of it but are open to the idea – consider moving somewhere with lower state taxes. These can include lower state income taxes or even states that don’t tax retirement income.

If you’re set for income needs and had planned to make a charitable contribution – consider doing it directly from a traditional IRA. Once you reach the age of 72, Required Minimum Distributions (RMDs) will kick in. The lower your balance, the lower the amount of RMDs.

Investment Strategies for Managing Income

Asset allocation is a strategy for diversifying your accounts across investment types. Asset location refers to a strategy for placing investments in accounts where they have the potential to lower your tax liability.

Taxable accounts, such as brokerage accounts, should hold tax-efficient investments. These include stocks you hold for more than a year; tax-exempt municipal bonds; and index funds. Tax-deferred accounts are good homes for tax-inefficient investments. These include equities, commodities, some alternatives, and other actively managed strategies.

If you have a Roth IRA, along with a traditional IRA, you may want to be thoughtful about your total income when determining which account to withdraw from. As a reminder, Roth account distributions aren’t subject to any taxes or RMDs, so taking from the appropriate account based on whether your income is likely to be higher or lower in any given year might lower your tax bill.

Converting to a Roth IRA may also be a good strategy – but you’ll need to think through when and how much you’ll convert, or your upfront tax bill could be significant. Staggering the conversion over several years can make paying the piper more manageable.

Conclusion

Retirement planning doesn’t stop with creating an investment strategy to generate the income you want. You’ll need to carefully think through the tax implications and make tactical moves today to help keep your retirement income as tax advantaged as possible. Doing so may have a lasting impact not only for you, but also for your heirs.

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