How to Reduce Taxes in Retirement

Nobody enjoys paying taxes when working full time. But when you reach retirement, paying taxes is even less appealing. 

However, much of the income you’ll receive in retirement—from Social Security, investments and other sources—will be taxable. You’ll continue to file a tax return and pay taxes each year, even in retirement. But if you want to hand over less money to Uncle Sam, you can take some steps to reduce your taxable income. 

What qualifies as taxable income?

Taxable income is all the income that is included in determining how much you owe in taxes. That includes both earned income and unearned income. Earned income is the money you make at a full-time job or other types of work like part-time or side gigs. Unearned income can include distributions from an investment account or, after age 62, Social Security payments.

What can I be taxed on in retirement? 

In retirement, some types of income are taxable while other types are not. Social Security and withdrawals from your 401(k) and any traditional IRAs are all taxable by the federal government. 

If you have income from a pension or an annuity, that income is also subject to taxes. And you’ll also pay taxes on any dividends, interest income or capital gains from regular stock sales, just like you did before you retired. 

Unless you live in one of the nine states that do not charge income tax—Alaska, Nevada, Florida, Texas, Wyoming, Washington, New Hampshire, South Dakota and Tennessee—your state will also charge taxes on this income. 

Withdrawals from Roth IRAs and Roth 401(k) plans, however, are not taxable because you paid taxes on the funds when you made the contribution to those accounts. 

Whether you will owe taxes—and the amount you will owe—depends on the amount of your total income, just as it does when you’re working. In retirement, your tax bracket is based on combined income, which means a combination of your adjustable gross income, nontaxable interest income and some portion of your Social Security. (The taxable amount of your Social Security depends on how much other income you have.) If your combined income is less than $25,000, you will pay no taxes. 

As a result, most people who have Social Security as their only income are exempt from paying income taxes. But even for those in the highest tax brackets, only up to 85 percent of Social Security income is taxable. (While it may seem like you’ve already paid tax on Social Security income once, the government has actually held that money for you until retirement and is now returning it to you, incrementally.)

What can I do to reduce taxes in retirement? 

If you’re more concerned about taxes in retirement than you are about taxes right now, one potential option is to start putting money into a Roth IRA or Roth 401(k). To qualify for a Roth IRA, individuals must earn no more than $124,000 in 2020 and couples must earn no more than $196,000. Those who qualify can contribute up to $6,000 in 2020, or $7,000 for people age 50 and older. 

Contributing to a Roth reduces your taxes in retirement because you pay taxes on the money before you put it into the Roth IRA. That means you don’t get a tax break now, but you will get one in retirement—withdrawals from the account are tax free, including both principal and earnings. 

With a traditional IRA or 401(k), the tax savings are on the front end instead: You get to deduct your contributions from your taxable income (depending on how much you make), but you pay taxes when you make withdrawals in retirement.

Another important way to reduce taxes in retirement is to lower your expenses. Pay off your mortgage and other debts before you retire. When you don’t have as many expenses, you won’t have to withdraw as much from your taxable retirement accounts—so your tax bill will be lower.

You could also move to a state that has more friendly tax laws. If you’re thinking about moving in retirement, look for a state that doesn’t have income tax or that doesn’t tax retirement income. 

Can I draw from investments in a way that reduces taxes? 

Yes, you can also manage your investment withdrawals with an eye toward taxes. If you have some funds in a traditional IRA or 401(k) and other funds in a Roth IRA or Roth 401(k), you can be strategic about how you take distributions.

In years when your tax bill will be higher—maybe because you’ve earned a lot of interest and dividends or you inherited some money—make withdrawals from your Roth, which will not be taxed. In years when your tax bill will be lower, you can withdraw taxable money to live on from your traditional IRA or 401(k).

During low-income years, you can also convert some of the funds in your traditional IRA to a Roth. You’ll have to pay taxes on the funds when you withdraw them from the traditional IRA, but then your funds can keep growing in a Roth and you won’t have to pay taxes when you need that money to live on in future years.

You’re now required to start taking distributions from your traditional IRA when you reach age 72, but can continue to make contributions, too. If you don’t need the money you take out to live on, you can reduce your tax bill by donating to charities directly from your traditional IRA. You can donate up to $100,000 per year from a traditional IRA and avoid paying taxes on it.

Even in retirement, taxes will play an important part in money management. But with careful planning, you can take strategic steps to keep your tax bill as low as possible.