How Can You Plan Now to Pay Less Taxes in Retirement?
It is likely that the tax rate will increase again by 2025. Instead of being caught off guard, start planning now to pay fewer taxes in retirement by taking a few important steps.
At present, the level of our country's national debt is about $23 trillion. This factor makes it all the more likely that the government may implement contractionary fiscal policies, like increasing tax rates. So, chances are that the tax rate will rise again after 2025.
If you are going to retire within the next 5 years, don’t procrastinate to plan ahead for this tax change. It may seem like a long time, but trust me, you can have a happier retirement if you plan yours in such a way that Uncle Sam can’t grab more than their fair share of your retirement nest-egg!
Why 2020 is the best time to start tax planning for retirement
The recent Tax Cuts and Jobs Act of 2017 have reduced the tax rate in the US for the first time in many years. As I said earlier, there is a high chance that the tax rate will increase after 2025.
If you are going to retire or opt for early retirement by 2025, you can start planning now to pay fewer taxes in retirement by taking a few important steps.
7 strategies to start today to save money on taxes in your retirement
1. Try to stay in the 12% tax bracket
If you keep your income in the 10% and 12% tax bracket, you can get a tax rate of 0% on your capital gains. To stay in the 10% tax bracket, your income has to be within $9,875 as a single person and, for married people filing jointly, your total income has to be under $19,750.
To stay in the 12% tax bracket, your income should range between $9,876 to $40,125 as a single person. And if you are married and filing jointly, your joint income should be between $19,751 to $80,250.
What are capital gains?
Capital gains are the income you earn from long-term investments like stocks, bonds, mutual funds, real estate, etc. If you’re within the 12% tax bracket, the profit you can earn from investments will be taxed at a 0% rate. The tax rates on long-term capital gains range from about 0% to 20%, depending on your taxable income and when you are filing.
In the 2020 tax year, the highest tax rate is 37% if you are an individual single taxpayer having an income of more than $518,400. If you are married and filing jointly, the top tax rate of 37% is applicable if the total income of you and your spouse exceeds $622,050.
2. Get your money into a Roth IRA
One of the easiest ways to trim your tax bill is to put money into a Roth IRA. You can consider converting your traditional IRA to a Roth IRA. But when you convert to a Roth IRA, you need to pay taxes on the converted amount.
The amount you convert is added to your gross income in that tax year. So, it increases your income and you have to pay your ordinary tax rate on the conversion.
You can reduce the amount you spend on taxes over your lifetime if you do the conversion in a year when you have low earnings. This helps you to take advantage of your current tax rates while you are stashing money for your retirement.
Let’s say, you expect to be in the 24% tax bracket during your retirement, but you have paid a 12% tax rate on the converted amount. Making the switch to a Roth IRA will allow you to decrease the tax due on your retirement nest-egg.
3. Time your retirement plan withdrawals or transfers just right
You can control your taxes by managing your withdrawals in retirement. Over the years, when you are in a low tax bracket, withdraw taxable money for your living expenses.
You can also convert your traditional IRA to a Roth IRA in those low-tax years. As we discussed in the above point, you need to pay taxes on the amount you convert to a Roth IRA.
If you do the Roth conversion, do it during your low-tax years, you will pay a lower tax rate. Plus, you are getting your money into a Roth where your money can come out tax-free. But make sure to convert enough into a Roth IRA so that your income doesn’t come under a higher tax bracket.
Over the years, when you are in a higher tax bracket, withdraw from your Roth IRA. Doing so, your income won’t be taxed at higher rates because you’ve already paid taxes on the funds at the time you contributed them.
Facts about withdrawing retirement funds early
Are you planning to cash out your 401k before reaching the age 59.5? If so, you will have to pay ordinary tax on the distributions. Additionally, if you are younger than 59.5, the IRS (Internal Revenue Service) will penalize you another 10%.
You can easily calculate how much you have to shell out if you want to cash out 401k early. You may not have that much amount in hand as you had hoped initially!
However, under the new SECURE Act, if you have recently become a parent or adopted a child, you can cash out up to $5,000 from a 401k without penalty.
So what do early-retirees live off when they leave the workforce before the traditional retirement age? They rely on their tax-exempt investments.
4. Make tax-exempt investments
Do you know what government bodies do when they need money? They release bonds!
Usually, these bonds are known as Municipal bonds or MUNIS, in short. Municipal bonds are tax-exempt. That means you won’t owe any federal tax on the income you receive.
By opting for MUNIS, you can make a smart move of saving money on your taxes. And I would say that it’s comparatively a safer option. You can get a federal income tax exemption and expect a much higher return than other investments.
You may find very rare instances where municipalities have gone bankrupt, but, don’t worry. Another option for you can be investing in annuities.
If you go for non-qualified annuities, you will have to pay taxes only on a part of your payments because you are already paying taxes on the principal you are investing in.
The taxable portion of your payments is determined by the “exclusion ratio”. This ratio is calculated based on the following factors:
- Principal you have invested
- Tenure of your annuity
- Your income is on the principal
However, if you have an annuity within a Roth IRA, then it can be tax-free! Always remember, with Roth, you’re using after-tax money so an annuity in a Roth grows tax-free.
5. Move to a state that doesn’t tax Social Security income
There are about 43 states in our country that collect tax on various forms of income. And that can be an additional burden for you as you need to pay more tax! However, 8 states have no income tax as of now, like:
- South Dakota
- Tennessee (By 2021, this state will become income tax-free)
6. Reduce your expenses by withdrawing less from your retirement accounts
I know you want to stay in the lowest tax bracket. For that, you have to reduce your expenses every month. You don’t have to withdraw much from your traditional retirement accounts. By doing so, you can stay in a lower tax bracket.
Here are a few ways to reduce expenses without sacrificing your lifestyle:
- Move to states that don't tax Social Security income. (See above) If you already reside in one of those states, that’s great.
- Plan your budget properly. A realistic budget can pave the way for your financial stability. Trust me, if you can stick to your budget, you can reduce your unnecessary expenses and save a substantial amount of money.
- If you have any outstanding accounts like credit card debts, you might not be able to reduce your expenses. You’ll have to shell out a substantial amount every month to pay off your debts. The Annual Percentage Rates (or APR) of credit cards are usually quite high. In that case, you can eliminate credit card obligations, and save those dollars for your financial well-being.
7. Take advantage of gift tax-exemption to reduce your taxable income
Gifts are a great way to reduce your taxable income while also helping individuals and organizations that are in need of financial support or funding. A gift can be anything. It can include money, properties, investments, etc. In most situations, the IRS doesn’t care too much about what you gift away, but it’s when someone gifts an excessive amount that they start to take notice and apply the gift tax.
What does the IRS consider an “excessive” gift amount?
The gift threshold changes every year and is known as an annual exclusion. In 2020, you can gift someone up to $15,000 without paying tax on it. The IRS also takes your lifetime gifting into consideration. In 2020, the lifetime exclusion is $11.58 million. If you gift someone more than the annual exclusion you need to file a gift tax return for that year and if that tips you over the limit of the lifetime exclusion, you will likely owe an additional tax liability.
Here’s an example:
Let’s say, you are giving $40,000 to your sister. That means you are using up your annual exclusion of $15,000. In this case you will have to file a gift tax return, BUT, most likely, you won’t have to pay a gift tax because the extra $25,000 ($40,000 - $15,0000) will be counted against your lifetime exclusion ($11.58 million).
However, there are also exemptions that are always applicable to certain gifts like:
- Gifts to charities that are approved by the IRS
- A gift to cover someone’s education fees (you need to pay directly to the educational institution)
- A gift to your spouse (but he/she should be a US citizen)
- A gift to cover someone’s medical expenses (you need to pay directly to the medical facility)
- A gift to a political organization
The truth about taxes
Love or hate them, tax dollars are a big part of what makes this country and its communities safe, beautiful, and operational places to live. When it comes to paying taxes, everyone should pay their fair share. The tips above are just a sliver of the hundreds of pages of the tax code that cover ways to minimize your taxes owed.
I hope this guide has given you a rough idea about how you can plan from now on to pay fewer taxes in your retirement. I mentioned what I consider to be the best possible way to beat taxes in your retirement, but if you have any other ideas on how to do it, let me know in the comments!
*This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.