- 3-Minute Article
3 Smart Strategies for Reducing Your Retirement Income Taxes
Learn how to navigate taxes in retirement and keep more of your savings for yourself.
The balance in your retirement accounts indicates just one thing: how much you have saved for retirement. It’s not an indicator of how much you’ll actually receive in retirement. Taxes are a big reason why.
Some portion of the savings in each of your retirement accounts will likely need to go to taxes. But since not all retirement income is taxed the same way, you can strategically withdraw from different accounts at different times to lessen the impact of your tax burden. The tactics that work best for you will depend on your age, level of income, and current and future tax brackets. That’s why it’s best to work with your tax advisor to develop a plan for minimizing your retirement taxes — and keeping as much of your money as you can.
1. When to claim Social Security
You know that waiting to claim Social Security until age 70 can increase the amount you receive each month. But did you know that taking a higher benefit can also help you with taxes? The more you receive from Social Security, the less you have to take from other assets to meet your desired retirement income — and the more those assets can potentially grow. (Until you reach age 70½. See No. 2 for more.)
On the other hand, you might choose to take a small amount of Social Security earlier and draw down more of your other retirement accounts to reduce the need to withdraw a larger, taxable required minimum distribution (RMD) later. (We get into that in No.2.) There are trade-offs for both scenarios.
2. When to tap your retirement accounts to minimize your RMD
The IRS requires you to withdraw from qualified retirement accounts after age 70½. It’s their way of saying you can’t delay those taxes forever.
The amount of your RMD is calculated based on your life expectancy and takes into account all of your tax-deferred retirement accounts, including 401(k)s, 403(b)s, 457(b)s, and traditional IRAs and SEP IRAs. It will be taxed as ordinary income — which is any money you receive that is not a gain on an investment — according to your tax bracket. For some people, their tax bracket goes down due to lower income in retirement. For others, however, it remains level or even increases. Talk with your advisor about the timing that works best for you and your situation.
3. How your other retirement income will be taxed
Knowing the basic retirement income tax rules can help you work with your tax advisor on a tax-efficient plan for turning your savings into income.
If you invest in . . .
- Annuities: For non-qualified annuities, you only owe taxes on the growth of your savings in an annuity, not the original amount you invested (called the principal or purchase payment). Because annuity payouts are made up of both principal and earnings, only the earnings portion of this income stream is taxable, at your ordinary income tax rates. Withdrawals before age 59½ are subject to an additional 10% tax.
- Traditional IRAs and 401(k)s: Your withdrawals will be taxed as ordinary income.
- Roth IRAs and 401(k)s: You won’t be taxed on any portion of your withdrawals, as long as you’ve had the account for at least five years and you are older than 59½.
- Non-retirement investment/brokerage accounts: When you sell an investment you’ve held more than a year, you’ll be taxed on any money you make at a capital gains tax rate of 15% or 20%, depending on your tax bracket. If you sell an investment you’ve held less than a year, the money you make will be taxed as ordinary income. Even if the money stays in your account, and you don’t withdraw it, you still pay taxes on the sale.
Whichever withdrawal strategy you choose, remember to revisit it often. Retirement planning isn’t a “set it and forget it” proposition — you may need to make course corrections along the way. Talk with your financial advisor and your tax advisor at least once a year to make sure your withdrawal plan is still the best one to minimize retirement taxes and help your savings last.