Getting Started: What’s Taxable in Retirement and What’s Not?

Here are tips for minimizing taxes in retirement. 

The first step to minimizing your taxes in retirement is knowing what is taxable and what is not. You can then take steps to avoid or limit taxes on your investments. Here is how the IRS treats the most common sources of retirement funding.

  • Income: You owe income tax on any payments you receive for work or benefits. This includes any salary or payments from a job (even a part-time one), your earnings as an independent contractor, and any income you receive from side businesses. It includes payments that third parties receive on your behalf. 
  • Investments: Investments are subject to capital gains taxes as soon as you sell them. For example, if you sell a stock for a profit, the money you make gets added to your income for that tax year.
  • IRAs: There are different tax rules for traditional and Roth IRAs. Any contributions made to a Roth IRA are taxable at the time of the deposit. Withdrawals from Roth IRAs, however, are not taxable. Traditional IRAs work the opposite way. Withdrawals from traditional IRAs are taxable as regular income, but contributions avoid taxes. It is worth taking the time to select the best retirement account based on your tax plans. 
  • 401(k): You use pre-tax dollars to make contributions to a 401(k), so the money isn’t taxable once your employer deposits it. However, like a traditional IRA, 401(k) funds are taxable once withdrawn. 
  • Some government benefits: Social Security is taxed as income when you start receiving it. How much you pay depends on how much you and your spouse receive and whether you file your taxes jointly or separately.
  • Inheritances: Inheritances generally aren’t taxed as income at the state or federal level. However, depending on the assets you inherit, you may have to pay some taxes. For example, if you inherit the right toA Guide to Minimizing Your Taxes in Retirement
  • Paying taxes is never enjoyable. It’s even less pleasant when it cuts into your retirement funding. Retirees get income from IRAs and 401(k) accounts, Social Security, and investments that they established while still working. Some of this money is taxable, and some of it isn’t. 
  • While you still need to file taxes every year after retirement, you can take steps, both before and after you stop working, to limit how much you need to pay. 
  •  receive money due to the person you are inheriting from, that money may be taxable as income. This is common if you inherit stock or other securities.
  • Merchandise wins: The IRS considers prizes as income, whether they are in cash, merchandise, or the right to receive some service, such as travel.
  • Company bonuses or benefits: Company bonuses and benefits are also counted as income by the IRS. They are, however, categorized as supplemental income and taxed at a flat rate of 22%. 

It is impossible to avoid paying taxes in retirement. However, you can take steps to minimize the amount that you have to pay. 

What You Can Do to Minimize Your Taxes

It’s impossible to avoid taxes during retirement, but how can you minimize what you have to pay? Here are some steps that you can take, both before and after employment, to reduce the effect that taxes have on your retirement nest egg. 

Diversify Your Income

It’s possible to diversify your income from retirement accounts to ensure that you do not get hit with a big tax bill. A retiree can accomplish this by having a mix of taxable and non-taxable retirement accounts. 

For example, you would typically withdraw a set amount from your regular taxable retirement account for monthly expenses. However, if additional income, such as gains from stock sales, moves you into a higher tax bracket, you will have to make an adjustment. 

If you withdraw your monthly expenses from a non-taxable account (such as a Roth IRA), you effectively lower your taxable income and may be able to return to the lower tax bracket. You can go back to using taxable accounts when extra income doesn’t change your tax status.

Understand the Different Types of Investments

There are many types of investments you can take advantage of to prepare for retirement. You can open a self-directed IRA account to get more control over which assets you have in your portfolio. In addition to stocks and bonds, you may opt for a less well-known type of investment. For example, some self-directed IRAs allow you to focus on real estate investments, while others are for expanding your precious-metal holdings. These accounts let you diversify your investments.

Consider Asset Location

Not all investments attract the same tax. Some are more tax-efficient than others depending on the asset type and how long you hold it before selling. For example, short-term capital gains (held for under one year) are subject to a higher tax rate than long-term capital gains.

To take advantage of the differences, consider asset location. Tax-efficient investments include index funds, tax-exempt municipal bonds, and stocks that you buy and hold for more than a year. You can keep these in taxable retirement accounts. 

Tax-inefficient assets perform best in tax-free or tax-deferred accounts, such as a Roth IRA. These investments may include REITs (real estate investment trusts), commodities, fixed-income assets, and short-term stock investments. When you put these in tax-deferred accounts, you get to preserve the gains, and they are tax-free or taxed at your regular rate upon withdrawal.

Lower Your Expenses

One of the surest ways to reduce your taxes in retirement is to lower your expenses. With a lower cost of living, you will withdraw less taxable income from your retirement fund. This will keep your effective income low, placing you in a low-income tax bracket. 

Move to a State With More Friendly Tax Laws

Some states are more tax-friendly than others. Nine states exempt Social Security from state income taxes. They also have very low or no state income tax compared to other places. These retirement-friendly locations include Tennessee, Arkansas, Arizona, South Carolina, Colorado, Nevada, Wyoming, Texas, Washington D.C., and Hawaii.

Stay in the 12% Tax Bracket

The 12% tax bracket is a great place to be if you’re retired because you can avoid many of the taxes associated with capital gains, and you won’t have to pay much to the IRS each April. For the 2021 tax year, to be in this tax bracket, you need to make less than $40,525 if you’re single or filing separately or $81,050 if you’re married and filing jointly. 

You can use a diversified range of traditional and Roth IRAs to strategically withdraw money to remain in this tax bracket. 

Tax-Loss Harvesting

Losses are a part of any investment portfolio. You aren’t going to win on every investment. That said, losses aren’t necessarily a bad thing when it comes to taxes. You can subtract the losses from gains to lower your tax obligations. If some of your investments are making losses and you want to let them go anyway, consider selling them and realizing the loss to reduce your tax liability. Note, however, that tax-loss harvesting doesn’t work for tax-sheltered accounts, only taxable ones.