How to Structure Retirement Income to Minimize Taxes

Taylor Ledbetter
| October 3, 2024 |

Retirement is a time to benefit from all of your hard work and consistent savings over the years. The thought of traveling, more family time, and even picking up a new hobby can be exhilarating. While it’s important to thoroughly enjoy retirement, it’s also important to plan for this income ahead of time and any tax liability that may come with it. Awareness of the tax impact of different income sources can help you reduce your tax bill and stretch your savings further into retirement.

There are many different sources of retirement income, each with different tax implications. Most of the time, this income usually includes a combination of:

  • Social Security Benefits: Depending on your total income, up to 85% of your Social Security benefits may be taxable.
  • Pension Income: This is usually fully taxable as ordinary income.
  • Traditional IRA Withdrawals: Distributions from these accounts (pre-tax) are generally taxed as ordinary income.
  • Roth IRA Withdrawals: Qualified distributions from Roth accounts are tax-free.
  • Investment Income includes dividends, interest, and capital gains, which may be subject to different tax rates.
  • Required Minimum Distributions (RMDs): Once you reach age 73, you must take RMDs from your pre-tax accounts. This distribution is fully taxed as ordinary income.

Optimizing Social Security Taxation

If you are trying to decide when to take your social security benefits, there are many factors to consider. This includes your income need, family health history, retirement account balances, increased benefits at different ages, and more. Let’s assume health is not a concern, and your retirement account balance(s) have enough to support you comfortably in retirement. From a tax planning perspective, it may be best to fund your retirement expenses by drawing funds from your IRAs or pre-tax accounts. By the time you file for Social Security, the account values will be smaller and may potentially reduce the percentage of Social Security benefits subject to taxation.

Retirement Account Withdrawal Strategies

The order to withdraw funds from your various accounts is also very important. It’s best to withdraw from taxable accounts first, then tax-deferred accounts, and finally, tax-free accounts (Roth IRAs). This strategy allows your tax-free assets to continue to grow while simultaneously keeping you in a lower tax bracket earlier on in retirement. This also allows you to do Roth conversions, giving you and your heirs a tax advantage.

Roth Conversions

A Roth conversion is the process of converting a traditional IRA to a Roth IRA. You pay taxes at the time of conversion, but this amount will grow tax-free inside the Roth IRA. Normally, this is done over a few years because you want to ensure you are not converting too much to bump you into a higher tax bracket. If you expect to be in a higher tax bracket later in retirement or if you want to reduce the impact of RMDs, a Roth conversion can save you a significant amount in taxes.

Managing Capital Gains and Losses

Managing your capital gains inside taxable accounts will greatly impact tax efficiency in retirement. If you hold stock in these types of accounts for more than one year and one day before selling, you will pay long-term capital gains tax rates on the gain only (typically 15%). Whereas any stock owned and sold in under a year, you pay taxes at your ordinary income rate. You can deduct losses up to $3,000 annually; the excess is carried forward indefinitely. You can strategically sell investments to offset gains with losses to reduce your taxable income. This is very helpful if you have large, embedded gains in your account from stock you have owned for a long time.

Assess the Impact of Required Minimum Distributions (RMDs)

The tax impact of RMDs may be significant. Your RMD is based on your account balance as of 12/31 of the previous year and your life expectancy. The bigger an account balance is, the larger the RMD. This is why starting withdrawals from tax-deferred accounts before 73 or doing a Roth conversion can help reduce the amount required to take out.

Qualified Charitable Contributions (QCD)

If you were unaware of the strategies discussed above and are 70 ½ or older, a QCD is a strategy to help with the tax burden RMDs may cause. You can transfer up to $105,000 (2024) from your IRA to a charity, which satisfies your RMD without increasing your taxable income. You don’t have to itemize your tax return because this contribution is not considered a deduction since it is not included in taxable income.

Tax planning in retirement is crucial for maximizing income and reducing the tax impact on that income. Understanding the tax implications of your income sources and implementing strategic withdrawal strategies can minimize that burden and preserve your savings. Tax planning doesn’t end when you retire. You will undergo life changes, such as selling a home or receiving an inheritance, which can affect your tax situation. It’s essential to consistently revisit your plan to account for these changes and maintain optimal tax efficiency.