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Follow This 5-Step Retirement Income Plan to Lower Taxes

Lower Taxes Retirement Income

Many investors don’t have enough interest-bearing accounts to live in retirement solely on the interest they earn from those investments. This means that many will need to start turning investment assets into cash in order to pay for living expenses once they’ve hit retirement age. This can lead to many unexpected tax expenses that prompt a larger sell-off than originally planned for, shrinking how long your assets may last. There are guidelines you can follow if you’re selling off assets in your retirement account that will maximize your earning potential while lowering your overall tax bill, even if you’ve already hit retirement age.

A financial advisor can help you optimize your retirement investments to save money on taxes.

How Investment Income Is Taxed

Most investment income becomes taxable when you benefit from the money or turn it into cash. How much you are taxed is going to depend on a number of factors such as the type of investment, what tax bracket you fall into and how long you held the asset before you sold it or received the cash. There are three main types of investment income where you could be taxed:

  • Capital gains: Whenever you sell an asset, like a stock, for more than what you purchased that asset, then you realize a capital gain. If you own the asset for less than a year then you are taxed at your ordinary income tax rate, but if you own the asset for longer then you’re taxed at a lower bracket between 0% and 20%.
  • Dividends: Excess profits from corporations can be paid out to shareholders via a dividend. There are two types of dividends: qualified and ordinary. Ordinary dividends are taxed at the ordinary tax rate like a short-term capital gain. Qualified dividends generally occur when you have held the asset for at least the last few months and are taxed at a lower rate, like long-term capital gains.
  • Interest income: Income that you earn on interest-bearing accounts, like a certificate of deposit (CD), is considered interest income. Most interest is taxed at ordinary income rates. Some investments are exempt from federal tax such as interest on municipal bonds and exempt-interest dividends.

Taxes on investment income can add up during retirement. That’s because you’ll be looking to cash in so that you can receive the necessary income to live off of. Having a better understanding of how you’re going to be taxed in retirement is the first step in preparing your finances to lower your overall tax bill.

Prior to retirement, you can choose beneficial investments to prepare for the later sell-off. Once you’ve hit retirement age, though, it’s important to take the right steps in order to limit your tax obligations.

5 Steps for Lowering Taxes on Your Retirement Income

Lower Taxes Retirement Income

Once you’ve entered retirement it can be difficult to prepare your financial portfolio to maximize your savings on taxes. However, all is not lost. There is a five-step process you can go through that could help you lower your overall taxable income as you start to cash in your retirement accounts.

1. Take Required Minimum Distributions

The first step in this process is to take your required minimum distributions (RMDs) once you hit age 72. If you don’t start taking your RMDs at that point, then you’re going to get hit with a 50% tax penalty on the difference between what you did withdraw (even if it’s $0) and what was required to be withdrawn. When you’re ready to tap into your retirement account, you should first check to see what RMDs are required and withdraw at least that amount.

Taking RMDs means you’ll be withdrawing income that’s taxed as ordinary income. Your options once the money is withdrawn is to either spend it, or you could deposit the money into a taxable brokerage account and have the money work for you in the market again.

2. Collect Your Principal From Bonds and CDs

Many people look to certain accounts, such as bonds or CDs, to generate a regular income for their retirement. This is an investment strategy you can start at any age. You can ladder CDs, for example, so that you have a regular amount of income coming and are able to take advantage of the best rates. Laddering simply means you are staggering the maturity dates of your investments.

This can be a good strategy if you continually reinvest the money back into the next bond or CD because you don’t typically have to pay taxes on your original principal investment. This means that you can withdraw the interest payments and pay tax on that or you can withdraw your principal, which you won’t be taxed for, and reinvest the rest. Holding the asset to its maturity date makes your principal non-taxable.

3. Withdraw Interest and Dividends From Taxable Accounts

The next step is to look at withdrawing the interest from your original investment, but leaving the principal in order to yield more interest down the road. This is one of the best ways to earn in retirement without having to worry about a ballooned tax payment from selling the principal, and it keeps your income opportunity high.

You’ll likely want to wait to withdraw interest or dividend payments until you’ve held the asset for long enough to lower the tax bill on those payments. For dividends, this means withdrawing from qualified dividends. For interest payments, the best case scenario is to withdraw interest from exempt accounts like municipal bonds or from any interest-bearing account if you’re not withdrawing more than the principal.

4. Sell Additional Assets to Close the Gap

If you’re receiving enough money in the first three steps to pay for your retirement expenses then you can stop there and not worry about the last two steps yet. If not, then you may have to move forward with selling more assets in your portfolio in order to cover the shortfall. This can be typical for investors that weren’t able to prepare their accounts with less taxable investments prior to retirement.

The first asset you can sell that could benefit you is any asset that you’ve lost value on. While you’ll receive a portion of your original investment back to pay for expenses, you can also use that loss to offset capital gains and lower your overall tax bill. You should also only sell assets, if possible, that you’ve owned for more than a year to take advantage of better tax rates.

5. Tap Roth Accounts Last

It’s generally a good practice to hold off on tapping your assets held in a Roth IRA or 401(k) for as long as possible, making it the last place you withdraw from. In most cases, these withdrawals are tax-free once you’re 59.5 years of age, as long as you’ve had the Roth account for more than five years.

Other benefits include the fact that Roth IRAs aren’t subject to RMDs and withdrawals are tax-free for your heirs if you die before you’ve depleted that account. This allows you to leave the money in your tax-advantaged account until you really need to turn that value into cash.

Investing in Tax-Advantaged Accounts

One of the best things to do to prevent large tax hits in retirement is to invest in interest-bearing accounts or assets that pay dividends over time. This can provide you an income you might be able to live off of during retirement so that you do not have to have large sell-offs that are unnecessary. Plus, you typically aren’t taxed when you withdraw your original investment amount.

There are also a few tax-advantaged accounts that you can incorporate into your investment strategy prior to retirement that may help your tax bill long-term. The four most popular accounts are:

  • Roth accounts: As previously mentioned, Roth accounts are beneficial in retirement because you can withdraw the funds tax-free and can even pass on the money tax-free when you die. These accounts are exempt from RMDs and your taxable income won’t increase from gains or at any point if you need to withdraw after you hit 59.5 years of age. You can even roll funds over to a Roth IRA at retirement if your only goal is to avoid RMDs.
  • Health Savings Accounts (HSAs): An HSA isn’t considered a retirement account but it has plenty of tax advantages that benefit you prior to retirement. Health care is expensive and could continue to be so for a portion of your retirement years. An HSA can be a strong savings vehicle for these costs and your contributions reduce your current taxable income. If you keep money in your HSA until age 65, you can withdraw for other expenses and it will be taxed as ordinary income.
  • Taxable accounts: Any taxable account that you invest in is funded with after-tax dollars. The biggest example is a traditional brokerage account. Taxable investment income from these accounts is taxed in the year it is earned as ordinary income. The largest benefits of these accounts are that they are exempt from RMDs and if you take a loss it can offset other gains.
  • Tax-deferred accounts: A strategy that involves investments into tax-deferred accounts, like your 401(k) or traditional IRA, is one that limits your tax obligations when you make contributions. This is typically part of any well-balanced retirement portfolio to lower your tax bill as you build your retirement income. These accounts are subject to RMDs and are taxed when you withdraw funds.

Bottom Line

Lower Taxes Retirement Income

Saving on taxes during retirement starts with proper tax planning before getting to retirement age. However, that’s not always possible. There are still things you can do once you hit retirement age to lower your tax bill and maximize how much you could earn for your post-working life. The five steps above are a great place to start and a good guideline to follow in order to minimize your tax hit. Consider working with a financial advisor if you’re looking for help maximizing tax advantages of your investments prior to retirement.

Tips for Retirement Planning

  • When preparing your income for retirement, you’ll probably want to make sure you have a strong financial plan. A financial advisor can help craft a plan for the future. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • Not sure if you’re saving enough for retirement? Try SmartAsset’s retirement calculator to help you figure out if you are on track.

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