How to Minimize Income Tax in Retirement

Paying income tax in retirement affects your retirement plans significantly. If you plan on spending a specific amount of money – say $100 – you may be left with much less after paying your income taxes.

This deficit forces you to either trim your budget or to spend unsustainably, and in both cases, you’ll end up miserable. So, what better way to avoid misery than to minimize paying income taxes in your retirement years?  Here are some of the ways you can reduce your income tax in retirement.

  1. Retire to low tax areas/states

Where you decide to settle when you retire has an impact on the amount of income tax that you will pay in retirement. Some states provide a significant tax incentive to retirees by avoiding to draw income tax from pensioners, but others impose an income tax, including on the retirees’ social security benefits. Moving to states that have friendly income tax laws for retirees could save your account a buck or two that could go a long way in making your retirement more comfortable.

  1. Understand qualifications and withdrawal charges/penalties

Qualified withdrawals from Roth IRAs are tax-free because contributions are tax deductible. On the other hand, distributions from traditional IRAs are taxable because the account is tax-deferred. Qualification for tax-free withdrawals in Roth IRAs are subject to the contributor attaining the 59½-year-old threshold and whose contributions were made for more than five years before reaching this age. Understanding this provision in the Roth IRA guidelines is important because withdrawals that do not satisfy this condition are treated as unqualified withdrawals, attracting income tax and other penalties.

For traditional IRAs, there are minimum required distributions (MRDs) which are mandatory distributions starting at age 70½, and if violated, they attract penalties and income taxes. Consequently, if you hold company stock in your traditional 401(k), you should consider a rollover into another tax-deferred account (i.e.  Traditional IRA. Cashing out, or converting the traditional 401(k) into a Roth IRA) otherwise you’ll attract additional income taxes.

  1. Diversification of post-retirement portfolio

Retirees can receive revenue from various sources depending on their investments, including; saving accounts, pensions, Social Security, rentals, tax-free Roth accounts, taxable brokerage accounts, bonds and more. Different investment vehicles attract different income tax conditions and rates. These revenue streams vary in taxation and can be fully taxed (rentals), partially taxed (Social Security benefit), taxed at the long-term capital gains rate (bonds) or not taxed at all (Roth IRA).

Asset allocation in a diversified portfolio takes advantage of the available regulations to leverage different tax provisions. When you consider a scenario where, as a retiree, you need to make a $10,000 withdrawal from a traditional IRA, you’ll incur an ordinary or marginal income tax. However, getting the same $10,000 from long-term capital gain accounts with an initial capital of $8000 would only attract a capital gain tax on $2000 worth of earnings.

To minimize your income tax in retirement requires the utilization of an array of techniques that optimize your retirement portfolio.

To learn and understand more about how to effectively minimize your income tax in retirement, register for a free tax planning event near you.

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