How To Minimize Your Tax Hit In Retirement

By Mark S. Gardner, CSSCS

Life after retirement can be full of changes and challenges, not least understanding how taxes will impact your income and deductions. 

Different tax rules can apply to each type of income you receive, so it’s crucial to make tax planning part of your comprehensive financial planning for retirement. 

You should know how each income source is taxed so you can avoid tax surprises that could cut into your retirement nest egg. Tax time each year is a good time to do an overall financial checkup, but tax planning for retirement is often overlooked or put off for too long. It’s essential to plan. Taking a long view and learning what you can do ahead of retirement will allow you to make your savings more tax-efficient.

Here are how some types of retirement income are taxed and ways to reduce those taxes:

5 sources of retirement income and how they’re taxed

• Social Security.  A portion of your Social Security benefits likely will be taxed if you have additional sources of income. The taxable amount, calculated by a formula, can be anywhere from 0 to 85 percent. 

• Pension. Most pension accounts are funded with pre-tax income, so the entire amount of your annual pension income will be included as taxable income each year. It’s a good idea to have taxes withheld directly from your monthly pension checks to offset the bigger hit at tax time. Unfortunately, the landscape has changed over the years; less than 20 percent of companies offer and support pension plans today for their employees. Since interest rates are at a historic low and people live longer, many companies allow individuals to withdraw their pension funds to manage the funds independently. Fortune 500 companies like Coors and General Electric have gone to Insurance companies to manage the employees’ retirement funds in fixed indexed annuities, which provide them with a guaranteed lifetime income stream.

• Tax-deferred retirement accounts. When you withdraw money from an IRA, 401(k), 403(b) or 457, it is reported on your tax return as taxable income and taxed at ordinary income tax rates. 

• Investment income. This comes from various sources – dividends, capital gains, interest income – and most of it is taxable. A sale of investment results in a short-term or long-term capital gain or loss. Any profits are taxable that year and are counted as part of your annual income, including gains made from real estate, brokerage accounts, bank products, and other assets.

• Annuity distributions. A qualified annuity – funded by pre-tax dollars – is subject to taxes at your regular rates when distributions are made. Taxes on both the investor’s contribution and the investment gains that accrued will be owed when the retiree begins taking withdrawals from the account. But distributions from a non-qualified annuity are not subject to income tax on the contributions. When you withdraw money on a non-qualified variable annuity, for example, only the earnings on your investment is taxable.

5 ways to reduce taxes in retirement

• Roth conversions. In contrast with tax-deferred retirement accounts, the money you withdraw in retirement from a Roth IRA or Roth 401(k) is tax-free. You pay taxes on the front end, but with tax rates still at historic lows, now is an excellent time to convert money from a traditional IRA or 401(k) to a Roth. In a Roth conversion, you pay tax on the amount converted in the year you move your money. So look at your income each year and convert as much as you can to a Roth without pushing yourself into a higher tax bracket for that year. There are no limits on the number of Roth conversions you may make, nor are there ceilings on the amounts you can convert. Beginning at age 59½, you can withdraw both contributions and earnings in a Roth without penalty, provided your Roth account has been open for at least five tax years.

• Tax-loss harvesting. Losses you incur on investments can counteract and minimize capital gains taxes or taxes owed on a regular income. In tax-loss harvesting, the investor sells an investment with lost value, replaces it with a similar investment, and uses the buy sold at a loss to offset any gains. It only applies to taxable investment accounts; retirement accounts that grow tax-deferred are not subject to capital gains taxes. For a married couple filing jointly or a single tax filer, up to $3,000 per year in realized capital losses can be used in tax-loss harvesting. Those married but filing separately can deduct up to $1,500 in one year for tax-loss harvesting purposes.

• Municipal bonds. These are debt securities issued by government entities. Municipal bonds are exempt from federal tax and usually exempt from tax in the state where the bond was issued. As a result, they can provide a stable income stream as the bond purchaser receives regular payments at a fixed interest rate.

• Whole life, premium finance, or indexed universal life insurance. A whole life insurance policy not only can provide money to your loved ones after you die. It also can help both you and them with taxes. Beneficiaries receive life insurance payouts tax-free. And if you need funds from the policy while you are still alive, you can access the cash value on a tax-advantaged basis. You have tax-free access up to the amount you’ve contributed through your premiums.  When a person does a premium finance life insurance policy, the bank helps finance between 50 to 90 percent of the policy premium. 

Another way to create tax-free income is to self-insure themselves without bank financing. This is done by purchasing an indexed universal life insurance policy. The policyholder can be receiving tax-free income from their policy by borrowing out money for the rest of their lives. If structured correctly through a trust, a premium finance life insurance policy can also be placed outside one’s estate and used to pay off estate taxes.

• Fixed-index annuities. With a non-qualified fixed-index annuity, only the interest earned is taxable when funds are withdrawn. As a result, investors can benefit by using income from a fixed-index annuity in conjunction with fully taxable withdrawals from other accounts to lower their overall tax rate in retirement. 

A great benefit from the fixed-indexed annuity is if one goes into assisted living or home health care and the annuity is in an individual's name, it pays out two times the original monthly payout for up to five years should the person be using the funds for health needs. If one person owns the annuity, you can annuitize it by placing it in the husband and wife’s name, and then it will pay one-and-a-half times the original payout if either one goes into a facility. 

Tax mistakes can significantly impact your money when you’re on a fixed income in retirement. So think ahead in detail about what you want your retirement to look like and how you can prevent taxes from clouding that picture.

About The Author

Mark S. Gardner is president of Retire Well Dallas, a wealth management company.