How to Reduce Taxes in Retirement

Four Methods:Diversifying Your InvestmentsReducing Taxes by Making Withdrawals in the Right OrderReducing Taxes By Selling AssetsReducing Taxes by Losing Wisely

By definition, retirees do not draw income from wages or salaries. That's a good situation, but for tax purposes, wages are simple. Since income in retirement moves from wages to diverse sources of income, understanding how to minimize your tax bill can get a little confusing. However, with a little effort, you can lessen your tax liability by thousands of dollars each year.

Method 1
Diversifying Your Investments

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    Invest in a traditional IRA. IRA stands for Individual Retirement Account, and they are among the oldest and most popular types of retirement accounts to invest in.[1]
    • Unlike Roth accounts, people of any income level can invest in a traditional IRA.
    • You can’t contribute more than $5000 a year to an IRA, or $6500 if you are over 50.[2][3]
    • You must pay taxes on withdrawals, but you cannot withdraw without penalty before age 59½.
    • You can deduct contributions to your IRA from your income for tax purposes.
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    Invest in a traditional 401(k). A 401(k) is a retirement sponsored by your employer. You defer pre-tax money into the retirement account, and many employers will contribute a matching portion to the account under certain conditions.[4]
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    Invest in Roth IRAs and Roth 401(k)s. Roth IRAs and Roth 401(k)s are vehicles for avoiding all tax liability on withdrawals.[7]
    • The contribution terms are the same with the Roth accounts as the conventional accounts. However, the contributions are taxed rather than the withdrawals. This is especially advantageous for those who anticipate making more money in the future and moving into higher tax brackets.[8]
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    Invest in stocks and real property. This is mainly to give you flexibility. You can invest as much or as little as you like, withdraw or liquidate at any time, and they typically have a better rate of return, although that carries with it more risk.[9]
    • This can be as simple as investing in a real estate fund or a mutual fund, or as complex as picking the stocks and real estate individually. Do what makes you comfortable.

Method 2
Reducing Taxes by Making Withdrawals in the Right Order

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    Take your MRDs first. MRD stands for Mandatory Required Distributions, which are amounts from your retirement accounts that have to be withdrawn after you have held them for a certain length of time or you’ve reached a certain age.[10]
    • Traditional IRAs, 401(k)s, and Roth 401(k)s all have MRDs. With traditional IRAs, the MRD begins at 70½ years. The two types of 401(k)s have the same age requirement, with the exception that for people 70½ who are still working.[11][12][13]
    • If the MRD is not taken, the amount of the MRD is taxed at 50%.
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    Withdraw from taxable accounts next. Taxable accounts include mutual funds, brokerage accounts, and any money realized from capital gains.[14][15]
    • You want to draw from these accounts first because the longer you live, the more you tap into your retirement savings, which diminishes them. At the end of life, you don’t want to see the money you use to live on taken by taxes.
    • These are called taxable because you invest in the account initially with post-tax income, and you pay whenever you receive the return on the investment. So if a credit union pays yearly dividends on a savings account, you have to pay taxes on those dividends each year.
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    Withdraw from tax-deferred accounts next. Tax deferred accounts include your regular 401(k) and your traditional IRA.[16]
    • These accounts are taxed upon withdrawal because pre-tax income is used to contribute to them, thereby deferring, or putting off, the tax.
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    Withdraw from tax free accounts last.. These are the Roth accounts. Withdrawals on Roth accounts are tax free, because after tax income is used to add to the accounts.[17][18][19]
    • You can withdraw from the contributions in a Roth account at any time, tax and penalty free.
    • You can withdraw from the earnings after 5 years and age 59½, tax free and penalty free. Prior to these time limits, withdrawals of earnings are still tax free, but not penalty free.

Method 3
Reducing Taxes By Selling Assets

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    Liquidate assets you have held for more than a year. This is known as a long term capital gain. The tax rates on long term capital gains are no more than 20% (but usually not more than 15%), which is less than income taxes, so selling off assets is a great way to lessen tax liability.
    • For it to count as a long term capital gain, you have to have held the asset for a year or more.
    • Collectibles are taxed at a higher rate than other capital gains—as high as 28%--but that is still lower than the tax on earned income.
    • The distributions from 401(k)s and IRAs are taxed at ordinary income tax rates. Therefore, you can liquidate all or a portion of an account like a 401(k) or an IRA at the beginning of retirement, make a capital investment with the money, and then sell it off after a year. Even if you take a loss on the investment, the loss might be less than the difference in tax liability.
    • Capital gains taxes are progressively bracketed like regular income taxes, just at lower rates. Charles Schwab provides a full table.
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    Try to hold onto assets for at least a year. The tax rates for short term capital gains are the same as they are for earned income, like wages and salaries. Hold onto assets for longer than a year to save big.
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    Get a reverse mortgage. Reverse mortgages are a type of home equity conversion loan that is marketed toward senior citizens.[20] The borrower gets a loan for the value of the equity in the home. The loan can be structured in three ways:
    • The loan can be structured as a line of credit.[21] The borrower can access the line of credit at any time for whatever reason, although there may be limits on how much can be accessed in a time period. The unused balance of the line of credit actually grows in value as the home increases in value.
    • The loan can be structured as a monthly payment for a fixed number of years, known as a term payment plan.[22] The buyer receives the same amount of money each month even if the value of the home decreases.
    • The loan can be structured under a tenured payment plan, which means that the buyer gets a monthly payment for as long as they remain in the home, even if the amount of payments exceed the loan value.[23]
    • Even if payments under the reverse mortgage stop, the homeowner cannot be evicted from the home.[24]
    • When the homeowner dies, the title to the house can pass onto their heirs, but the heirs have to satisfy the amount of the loan or forfeit the deed. For this reason, reverse mortgages should usually be a last resort.[25]

Method 4
Reducing Taxes by Losing Wisely

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    Itemize deductions. Many retirees don’t itemize deductions, leaving billions to the IRS every year. Many retirees seem to forget about the deductions for medical expenses and charitable contributions in particular. Make sure you’ve discussed possible itemized deductions with your financial planner at length.[26]
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    Minimize liability with charitable contributions. Most people know that charitable contributions are tax-deductible. However, if you donate assets to charities wisely, you can really minimize your tax bill.
    • For example, if you want to donate $500 to a charity, instead of donating it in cash, you can donate $500 worth of stock that has appreciated in value while you’ve held it. That way you can claim the deduction and avoid paying the capital gains tax on the stock.[27]
    • The reverse goes if you’ve lost money on a group of stocks. Sell first, then donate the cash. That way you can use a capital loss to your advantage and deduct the contribution from your income for the year.[28]
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    Bundle your losses to minimize liability. This is known as loss harvesting, and it is a simple if overlooked way to minimize your tax bill.[29]
    • Your capital gains and losses can either be short or long term. You are entitled to use the net figure from all of these categories to arrive at one single figure.
    • So add up your long term gains (LTG) and losses (LTL). If your LTG is 10k and your LTL is 5k, that’s a net LTG of 5k.
    • Then add up short term gains (STG) and short term losses (STL). STG of 6k plus an STL of 7k is a STL of 1k.
    • Then add the net LTG and the net STL to get 4k in taxable LTG.
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    Find a trustworthy accountant. A lot of tax issues are complex, so an accountant can help. Remember though, many people use an accountant already, and nonetheless fail to take advantage of every break available. You need to do your own research.[30] Ask a prospective accountant the following:
    • If they are a licensed CPA. The CPA designation denotes a level of education and expertise that you can't guarantee otherwise.
    • How long their firm has been in existence.
    • What other certifications are held by CPAs in the office. This can give you an idea of their focus. The Personal Financial Specialist (PFS) and Certified Financial Planner (CFP) designations can indicate particularly helpful specializations for reducing taxes in retirement.
    • Whether you can contact any of their clients for a referral. A reputable firm should have no problem with this.

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Categories: Retirement