Navigating Taxes in Retirement: Strategies to Minimize Your Tax Burden

Retirement may offer a reprieve from the daily grind of working, giving you more time and flexibility to pursue new interests, travel, or relax at home. Although you may not be obligated to work anymore, you're not wholly exempt from other financial obligations, such as paying taxes. Prevent tax burdens from eating up your hard-earned retirement income by understanding the tax implications on certain retirement accounts and adopting effective strategies to reduce your taxes upon retirement.

Understand the taxes on retirement accounts

Taxation on your retirement savings accounts can vary greatly depending on the account type. Here's a list of the expected taxes you may need to pay on specific retirement plans to help you plan your retirement better.

Traditional IRAs or traditional 401(k)s

An individual retirement account is an arrangement you set up with a financial institution to save money for retirement. As it allows pre-tax contributions, a traditional IRA may benefit you if you expect to be in a lower tax bracket when you begin making withdrawals.

Once you reach age 59 ½, you may begin making withdrawals from this account without penalty. The money on this retirement savings account grows tax-deferred, meaning you can delay paying taxes until withdrawal. Once you withdraw from a traditional IRA, you owe taxes on the earnings portion, which is assessed at your regular income tax rate.

The same regular income tax rate is applied to traditional 401(k), 403(b), or 457 salary reduction plans. These accounts comprise your contributions, your employer's contributions, and the earnings, all of which are taxed at the regular rate. Withdrawals on pension plans are also subject to being taxed at your regular income tax rate.

Roth IRAs or Roth 401(k)s

A Roth IRA allows you to make after-tax contributions, which grow tax-free. This retirement account is ideal if you may be in a higher tax bracket when you begin making withdrawals. You may withdraw contributions you made to your Roth IRA at any age, tax- and penalty-free. Once you reach age 59 ½, you may take penalty-free and tax-free withdrawals on both contributions and earnings if you've held the account for five years.

A Roth 401(k) is a retirement savings account in which your employer contributes after-tax dollars from each paycheck, meaning the income tax is already paid when contributed. This retirement plan also offers tax-free withdrawals once you reach age 59 ½ and have held the account for five years.

Social Security benefits

Social Security benefits are a monthly payment that can form a portion of your retirement income when you reduce working hours or cease working altogether. These benefits are available after retirement once you reach a specified age, depending on your birth year. For example, if you were born in 1960 or later, you may receive full Social Security benefits at age 67. Social Security benefits are subject to a federal income tax, depending on your filing status and combined income, which may be up to 85% of your benefits.

Fixed annuities or multi-year guaranteed annuities

Fixed annuities are retirement savings vehicles that allow for tax-deferred accumulation of your contributions at a fixed interest rate for a predetermined time. Instead of an employer-sponsored savings account, it's a contract between you and an insurance company. The taxes owed on annuity income depend on how you fund the annuity.

If the annuity is funded with pre-tax dollars from a 401(k), the income is subject to ordinary taxes. However, if it's financed through a Roth IRA, it's not subject to taxes. Since these plans are already tax-deferred, using annuities does not provide an additional tax benefit. Consider consulting your financial adviser to navigate these complexities. They can help you plan your retirement strategy and potentially reduce your tax burden.

How to avoid penalty taxes on retirement plans

One of the best ways to minimize the tax burden on your retirement plans is to avoid early withdrawals. You may make penalty-free withdrawals on a 401(k) after you reach age 59 ½. However, if you make an early withdrawal before you reach age 59 ½, you may be subject to a 10% penalty tax on the amount withdrawn.

Once you reach age 73, you are obligated to withdraw minimum distributions from your 401(k) or IRA. Otherwise, you will likely owe a 25% penalty tax on the amount that should have been withdrawn.

How to reduce your tax burden in retirement

Having a good gauge of your retirement savings accounts and the types of taxes owed can be a great financial plan for ensuring you have sufficient funds to support your retirement lifestyle. Still, you can adopt a few more strategies to reduce your tax burden in retirement. Consider the following strategies:

Move money to a non-taxable retirement account

If your retirement savings are currently in a tax-deferred account, such as a traditional IRA or 401(k) account, you will eventually pay taxes in retirement once you begin making withdrawals. You may wish to consider moving the money into a Roth IRA or 401(k).

Although you may need to pay taxes on it, once transferred, the money can grow tax-free, and you will not need to pay taxes whenever you withdraw. Once you've moved your money into a Roth IRA or 401(k) (and paid taxes on the transfer), you could fund your account with a multi-year guaranteed annuity for guaranteed growth over a specific period. Try our online income annuity quote calculator to start your reduced retirement tax burden journey.

Diversify your retirement accounts

The more retirement accounts and different types you contribute to, the better control you can have over your taxes in retirement. Spreading your money across tax-deferred and tax-free retirement savings accounts can reduce your tax burden as specific withdrawals are taxed differently. Diversifying your retirement portfolio may also help you manage risk to prevent significant money loss and set you up with long-term financial stability to maintain a healthy and happy retirement for the rest of your life.

Avoid changing tax brackets

When you retire, you may be in a different tax bracket than when you were actively working. This change depends on your retirement income, which can move you into a higher tax bracket if it's too much. When you enter a higher tax bracket, you may owe more taxes.

Additionally, a high retirement income can affect the taxes owed on your Social Security benefits and may increase your Medicare premiums for health insurance. Consult with your financial advisor on an effective strategy to prevent a bump in your income that may affect your tax bracket. You can discuss your options for tapping into your retirement accounts at different times or switching to tax-free accounts.

Develop a tax strategy before you reach age 73

Whether you have yet to reach your desired retirement age or intend on a delayed retirement, you must develop a strategy for what to do when you reach 73. RMDs kick in at age 73.). You will have to pay taxes on the distributions, which are assessed at your regular income tax rate. It may be beneficial to start making withdrawals before you reach age 73 in case the RMDs are large enough to push you into a higher tax bracket, subjecting you to higher taxes.

Review your tax situation whenever you make life changes

Perhaps you're looking forward to relocating during retirement or intend to continue working past retirement age. Something unexpected could happen during retirement, such as increased healthcare costs or returning to work part-time after taking a sabbatical. Significant life events can affect your tax circumstances, requiring you to owe more or fewer taxes. Discuss your tax potential with your financial adviser to develop a realistic plan based on your retirement lifestyle.

Use the 4% withdrawal strategy

The 4% withdrawal strategy is popular among retirees as a smart way to manage retirement income for at least 30 years. You would withdraw 4% of your savings in the first year of retirement and then adjust the base amount for inflation in subsequent years.

While this strategy may be a good rule of thumb, it does not factor in market fluctuations, healthcare costs, and personal tax rates, whose effects differ with each individual. It can be helpful to start using your retirement savings, but it may need to be adjusted if your savings decrease faster than expected.

Make lowering taxes part of your retirement plan

Although retirement frees you from certain obligations, you may be unable to avoid paying taxes on your retirement savings. Some accounts, such as Roth IRAs and Roth 401(k)s, offer tax-free withdrawals once you reach age 59 ½ and have the account for at least five years. Further, you can reduce your tax burden on the growth of your retirement assets and ensure better retirement financial security by diversifying your portfolio and contributing to a fixed annuity that can provide you with guaranteed income in retirement. If you're ready to learn more, check out our intuitive fixed annuity guide.

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