How can I save on taxes?

August 17, 2023 | David Edmisten, CFP®

How can I save on taxes in retirement?

After working for the majority of one's life to save enough to retire, the last thing most potential retirees want to do is give back a large portion of their next egg to the government in the form of taxes. 

Of course, everyone is required to obey the tax laws and most want to avoid undue penalties or worse, by running afoul of the IRS. But within the limits of the tax code, there are several strategies that early retirees can use to minimize the amount of their assets that are subject to high taxes in retirement.

Most corporate employees have access to a qualified retirement plan through their employer while working, such as a 401k plan or similar. These plans can be great vehicles for accumulating wealth, as they offer high tax-deductible contribution limits, and often include matching contributions from the employer to further enhance one's savings. 

But when one enters the distribution phase of retirement, qualified plan balances can be one of the largest sources of taxable income. In retirement, all withdrawals from qualified retirement plans are taxed as ordinary income to the account owner at the time of withdrawal. 

And under current law, at ages 72-75, qualified plan and IRA owners are subject to mandatory Required Minimum Distributions from these accounts. At 4% or higher withdrawals each year, this mandatory distribution can create a large amount of taxable ordinary income in retirement.

Early retirees may also have additional sources of potential tax liability in retirement. Capital gains on stocks, real estate or other investments can be realized and taxed; pension, social security or part time employment income can be another source of tax liability; and interest earned on savings accounts, CD's or bonds can also add to one's tax bill. 

There may be additional tax considerations that come from life events in retirement, such as the sale of a home, collection or receiving an inheritance.

Each of these items potentially creates some form of tax liability for the early retiree. 

Each type of asset or income may have different types of taxation applied; for example, savings account interest, most bond interest, and withdrawals from qualified pre-tax accounts are taxed at ordinary income tax rates. But long-term capital gains on stock sales, real estate and primary home may have more favorable tax treatment. 

And withdrawals from Roth IRA and Roth 401k balances, if done correctly, have the potential to be completely tax free. 

Inherited retirement accounts under rules passed by Congress in 2020 now often have to be withdrawn within a maximum of 10 years and can be fully taxable income for the inheritor, adding an additional layer of complexity to an early retiree's tax situation.

With all the various pieces and potential tax implications for each type of asset and withdrawal, many early retirees feel overwhelmed navigating the taxes on their retirement income. 

Many early retirees go it alone and end up making costly tax mistakes in the way the use their assets in retirement. Some planning mistakes can result in as much as 40% of a retiree's assets being given to the government in the form of taxes. 

But the tax code also offers a thoughtful early retiree the opportunity to legally and efficiently reduce their tax burden in retirement. 

A carefully structured withdrawal plan can maximize the value of tax advantages such as lower long term capital gains rates, tax free Roth IRA withdrawals, tax free interest from municipal bonds, charitable giving, and proper timing for the use of each type of asset to create a much more tax-efficient income plan. 

Beyond merely creating a sufficient monthly retirement paycheck, a well thought out tax minimization withdrawal plan has the potential to save an early retiree tens of thousands of dollars in taxes over their lifetime.

Get your free guide on the Top 5 Retirement Mistakes (and How to Avoid Them) here!

Want to get a free assessment to see how well you are prepared for taxes in retirement?  Schedule a call with us today.

About the Author:

David Edmisten, CFP®, is the Founder of Next Phase Financial Planning, LLC, a financial advisor in Prescott, AZ. Next Phase Financial Planning provides retirement, investment and tax planning that helps corporate employees retire with both financial and lifestyle security.