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Retirement Tax Strategies to Consider

retirement tax strategies

Ideally, once you retire, you won’t have to work ever again. This is great, but for most people, it also means there’s no new money coming in the door. You have your savings and your investments and that’s often it. Every new cost and expense eats into that nest egg. Taxes are no different. Every dollar you pay in taxes is a dollar you can’t spend on yourself. So, both while you’re planning for the future and you’re managing your assets in retirement, it’s wise to maximize your tax advantages. Here are five good strategies to get you started. You can also work with a financial advisor to get tax strategies that are specific to your situation. 

1. Maximize Roth Accounts

Let’s consider two hypothetical investors. Both pay 10% in overall taxes on their retirement portfolios in which both have invested $10,000. After 20 years, at the S&P 500 average 10% rate of return, both investors have about $73,000 in this portfolio, which you can calculate on your own. One investor used a traditional IRA while the used a Roth IRA account.

The investor with the traditional IRA will pay $7,300 in taxes when they withdraw this money in retirement. The investor who used a Roth IRA paid $1,000 in taxes before making their first investment. Now, eagle-eyed readers will note that these are not accurate numbers for tax brackets. Instead, the point is more simply to demonstrate how significant the advantages are with Roth accounts. They are almost always the best option when it comes to tax planning.

The money you’ll invest does get taxed at the higher income tax rate, while standard retirement accounts, like an IRA or a 401(k), get taxed at the lower rate reserved for investments. However, that difference pales in comparison to not paying any taxes on the years of accumulated growth in your portfolio. For most investors, this is the single best thing you can do to plan for retirement.

2. Time Your Withdrawals

As with your working life, in retirement, your taxes will depend on your income for any given year. The more money you make, the more taxes you’ll pay. So time your investments and withdrawals accordingly. Withdraw money from your account in years when you have less income from all sources. Reinvest dividends and interest in more profitable years. This will help keep your taxes both more stable and lower, reducing your bill overall.

Although it’s worth noting that this is a strategy that mainly applies to income investment. Capital gains have only three brackets, 0%, 15% and 20%. At the time of writing the 20% bracket doesn’t apply until you’ve made over $450,000 single/$500,000 married in a single year, so very few retirees will ever need to worry about their capital gains tax brackets in a given year.

3. Invest in Government Bonds

retirement tax strategies

For many retirees, government bonds are an excellent way to maximize both security and tax advantages. As a rule, U.S. Treasury bonds are exempt from both state and local taxes. Investors also pay no federal income taxes on their income from municipal bonds. Together, these two assets create strong advantages for investors looking to reduce their overall tax burden.

Now, for most investors, the drawback to government bonds is their relatively low rate of return. These are highly secure assets and because of that, they tend not to pay much interest. That’s a problem for someone looking to build wealth, but for retirees who have already reached their goals the security gains of a government bond may significantly outweigh the lower yields.

Roll the money into Treasury and municipal bonds and you can capture both the tax savings and the security, without having to worry about strong growth that you may not necessarily need.

4. Leverage Sequence Risk For Tax Harvesting

Sequence risk is the quiet fear of all retirees. This is the possibility that you will make investments while the stock market is up then, in retirement, experience a bear market and be forced to sell those investments while the market is down. You’re caught between a rock and a hard place. You must sell assets because that’s how you get your income. But, since the market is down, you’ll take a loss on those sales.

It isn’t always possible to avoid sequence risk, but you can try to make some use of it. If you have to sell assets for a loss, time those sales to offset potential gains as much as possible. That way you can engage in what’s called tax-loss harvesting, using capital losses to offset capital gains in a way that reduces your taxable profits for the year. It’s not as good as making money, but it can reduce the pain of taking losses.

5. Build a Tax-Advantaged Withdrawal Strategy

Traditionally, financial advisors recommend a three-tiered withdrawal strategy in retirement. First, withdraw from fully taxed accounts that didn’t give you any tax benefits. Then, withdraw from tax-deferred accounts like 401(k)s and IRAs. Finally, withdraw from post-tax advantaged accounts like a Roth IRA. This allows you to maximize years of growth based on each account’s tax advantages.

Fidelity Investments has an alternative strategy that they map out, in which investors make proportional, simultaneous drawdowns from all three categories of accounts based on their needs. Their analysis suggests that, for the right investor, this can improve tax advantages beyond the traditional approach.

However, in both cases, the lesson is the same. Managing your withdrawals based on an account’s tax status can net you significant savings over the lifetime of your retirement. Building a strategy around how you make those withdrawals will pay off handsomely in the long run.

Bottom Line

retirement tax strategies

Lowering your taxes can be a very effective way to extend the life of your retirement accounts. From capitalizing on sequence risk to maximizing Roth IRAs, there are plenty of options to try and lower the amount of taxes you’ll pay when it comes to withdrawing funds in retirement. It’s important to identify the right strategy for your specific situation before deciding to withdraw money so that you don’t end up on the hook for more tax liability than you need to pay.

Tips for Retirement Tax Planning

  • You don’t have to prepare for these risks on your own. In fact, you can work with a financial advisor to adequately plan out your retirement and make sure you’re taking the necessary steps. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • We talk a little bit about sequence risk, but that’s a subject that deserves much more than a quick glance. Learn all about it so you can prepare for sequence risk yourself.

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