When you think about your projected living expenses in retirement, what cost categories come to mind? Food? Check. Utilities? Check. Medical expenses? Check. Travel? Check. Retirement taxes? Uh-oh. That's right — you'll still be paying taxes in retirement. When most of your taxes are deducted from your paycheck, it's easy to forget that you're paying them at all. But when you're retired, you'll be writing regular checks to the Internal Revenue Service (IRS).
Some advanced planning, however, could help give you some control over your taxes on retirement income.
For Your Consideration: Taxable Accounts
The amount you pay in taxes in retirement will depend on your level of income and may include taxes on a portion of your Social Security benefits, according to the IRS. The amount will also depend on whether some of your retirement savings have already been taxed. Savings accumulated in a Roth individual retirement account (IRA) or Roth 401(k) are generally tax-free in retirement because you don't get a tax deduction for the money you put into them. There are income limits for Roth IRAs, but they could be a compelling option if you're eligible.
If you put your retirement savings into a taxable account, you're taking a pay-as-you-go approach regarding taxes. What does this mean? Unlike with a traditional IRA or 401(k), the money you withdraw from a taxable account could either be tax-free or taxed at a lower rate.
Tax Benefits of Doing Good
Depending upon how much wealth you've accumulated by the time you retire, you might have some additional opportunities to minimize your taxes and give to a charity. With guidance from an estate planning attorney, you could set up a charitable remainder trust. Charitable remainder trusts essentially let you set aside assets, such as cash, securities or real estate, that will ultimately be given to a charity when you die. These trusts come in many varieties, and you're allowed to receive income generated by those donated assets after you place the assets in the trust. You can also take a tax deduction on a portion of the amount of the donated assets every year.
The Munis Exemptions
Then, there's the tried-and-true municipal bond strategy. Municipal bonds, which are also called "munis," are bonds issued by states, municipalities and select local public entities, such as school districts. The interest you receive from municipal bonds is exempt from federal income tax. If you live in the same state as the bond's issuer, you typically won't have to pay state income tax on that interest either. These tax exemptions could make municipal bonds an enticing option for your retirement strategy.
Gains, Dividends & Tax Rates, Oh My!
First, examine the tax rate on long-term (i.e., an asset you held for at least a year) capital gains. Capital gains are the profit you make when you sell an asset, such as a stock, for more than you paid for it. Next, check out the tax rate you'll pay on most stock dividends — which are the shares of profits many companies pay out annually to their shareholders. Finally, compare these rates to the tax rate on ordinary income.
Do you see the difference? The tax rate on long-term capital gains and qualified dividends is generally lower than it is on ordinary income. In fact, as a result of the December 2017 federal tax overhaul, Tax Cut and Job Act, for the 2020 tax year single taxpayers with incomes up to $40,000 and couples filing jointly with incomes up to $80,000 have a tax rate of zero on their long-term capital gains and qualified dividends, according to Forbes. (The tax rate may be 15 percent or more for those in higher income brackets.)
Why does this matter? Here's why: When you withdraw money from your traditional IRA or 401(k), all of it will be taxed as ordinary income — despite the fact that much of it will be attributable to the growth in the value of the stocks in your account, as well as accumulated qualified dividends. This means you may need to pay more in retirement taxes, depending on your income.
With careful planning, you could help minimize your retirement taxes. Of course, it's not always easy to find the right path for you. Speaking to a financial representative could help you get on track for tomorrow.