We all want to enjoy our retirement years with the most after-tax income possible. Here are six strategies you can use to reduce taxes and maximize your retirement wealth—whether you are planning for the future or have already retired.
Allocate Investments to Accounts with Taxes in Mind
The kinds of accounts you use to hold particular investments—and the order in which you take funds from them—matters for your tax bill when you’re retired.
- Long-term capital gains and dividends from taxable investment accounts are taxed favorably at low rates. By contrast, distributions from employer retirement plans, such as 401(k)s, generally are taxed as ordinary income, as are Traditional IRAs. So even though these plans are “tax favored,” they can increase the tax you pay on capital gains and dividends.
That means you should design your retirement savings portfolio so that your taxable accounts hold low-tax capital gain- and dividend-producing investments (such as stocks), plus tax-exempt bonds and tax-deferred annuities. Keep investments that produce fully taxable income (such as bonds and CDs) in tax-deferred accounts.
- After retiring, withdraw funds from your taxable accounts first. Keep tax-deferred retirement plans and IRAs intact as long as possible to maximize the pre-tax compounding of investment returns.
Move Funds from Employer Plans to IRAs of Your Own
Employer-provided qualified retirement plans have their own distribution rules, which are set by the employer. Those rules may not best meet your needs, especially as those needs change. Say, for instance, you retire at 66. You may not want to start withdrawals immediately, but your employer’s plan rules may require it. Rolling over these funds into an IRA can give you far more control over timing distributions, and when they will be taxed:
- Traditional IRAs have no required minimum distributions (RMDs) until you reach age 70½. This means you can delay owing any tax on your savings in them until then, when you may be in a lower tax bracket.
- Roth IRA distributions are tax-free and not subject to RMDs at all (further extending possible tax-free compounding of investments). So consider converting some or all of your Traditional IRA savings into a Roth IRA. A conversion makes the value of the Traditional IRA funds subject to income tax. But you may be able to do the conversion in a year when your tax bracket is low—such as just after retiring, or when you have unusually large business expenses, losses or other deductions. Taking advantage of that one year (even planning it) may provide many following years of net tax savings.
Reduce Tax on Social Security Benefits
Social Security benefits are taxable, and the portion of them that is taxed increases with your income. In 2017, 85 percent of benefits to individuals with provisional income of more than $34,000, and married couples with income greater than $44,000, are taxed. To minimize tax on Social Security…
- Delay taking benefits until as late as age 70. Your benefit increases each month you delay taking it. For persons born from 1943 to 1954, normal retirement age is 66, and delaying benefits increases your final benefit by 8 percent per year—a total of 32 percent by age 70.
This effectively provides tax-deferred growth for your benefit, as you avoid paying four years of taxes on it as it grows. This is extra advantageous if you expect your tax bracket at age 66 to be higher than after age 70, because, say, you plan to still be working at 66.
- Maximize retirement funds not counted in income when calculating tax on Social Security. Roth IRA distributions are not counted, another reason to consider converting a Traditional IRA to a Roth. Neither are borrowed funds (see next item).
Borrow Against Life Insurance or Home Equity.
Borrowed funds are not taxable income. So by borrowing wisely—instead of taking taxable gains and retirement plan withdrawals—you leave more funds invested in retirement accounts. Plus, to increase future usable liquid wealth, you can also keep investing the amount that would have been paid as tax on gains and withdrawals.
- Many people when young protect their families by buying whole life insurance. After the children are grown and house is paid for, they no longer need it. They can borrow against the insurance policy’s value tax-free. The loan can be paid off from the death benefit, so no cash repayments need be made. You get tax-free cash now at the price of a reduced death benefit you don’t need.
- A home-equity loan or reverse mortgage also provides tax-free funds. Repayments on an equity loan provide a deduction for mortgage interest, while a reverse mortgage typically requires no repayments until the homeowner dies or sells the home.
Limit borrowing to replacing intended investment liquidations or retirement plan withdrawals—just what you need to keep your retirement savings intact. Beware borrowing recklessly to increase spending and reduce wealth.
Give to Charity Strategically
Many people like to give to charity in their later years. Gifts to charity generally are deductible—but knowing the rules may make your tax benefit even larger.
- Donate securities and assets that have appreciated in value instead of cash. Say you donate cash today then later sell appreciated assets to fund your living expenses. When you sell the assets you’ll owe capital gain tax to the IRS. If, instead, you donate the appreciated assets to charity, you’ll get the same deduction but avoid ever paying the gain tax. You can spend what you would have had to pay in taxes on yourself.
- Plan to make Qualified Charitable Distributions (QCDs) from your Traditional IRAs on reaching age 70½. A QCD lets you transfer up to $100,000 directly to a charity without counting it as a taxable withdrawal from the IRA that increases your Adjusted Gross Income (AGI). This is a big benefit because a higher AGI can have many costly effects—limiting deductions while increasing the Medicare surtax, Medicare premium cost, tax on Social Security benefits and the total tax you owe. QCDs also escape the normal rule that limits charitable deductions to 50 percent of AGI.
Because of these benefits, you might want to defer making charitable gifts until age 70½, then make them through QCDs.
Get Tax Subsidies for Retirement Travel
If you are planning to see the country or travel the world during your retirement years, let the IRS help you.
- A recreational vehicle or boat can quality as a “second residence” for tax purposes if it has a kitchen, sleeping quarters and bathroom. That means you can deduct mortgage interest on a loan used to buy it, and deduct property taxes and other items under normal tax rules that apply to residences. Of course, one can qualify as your primary residence, too.
- When you rent out your home for up to 14 days, all the income you receive is tax free—you don’t even have to report it to the IRS. Use the rent you receive to pay for your own “IRS subsidized” vacation during the same period. This can be a tremendous break if you live near a special event like the Kentucky Derby, where you may get a very high rent for its duration. (Web services—Airbnb.com and HomeExchange.com, for instance—make renting out your home and simultaneous home swapping easier and safer than ever before.)
Deciding What’s Best
Not all of these ideas will apply equally to everyone, so be sure to consult your tax advisor to plan how to make the most of those that are best for you.