When it comes to retirement planning, you'll need to consider how much you need to save, where you want to live and how taxes will impact your retirement.
After all, just because you retire doesn't mean you get to stop paying taxes—sorry! Depending on your specific retirement plan, taxes will be taken out of your retirement account withdrawals. But by thinking about your potential taxes ahead of time, you can maximize your retirement income and minimize your taxes.
Here are some of the strategies you can implement for a tax-efficient retirement.
1. Understand Your Retirement Accounts
Different types of retirement accounts are taxed differently. As you prepare for retirement, make sure you understand the tax implications of each of your accounts.
For example, the money in your 401(k) and IRA accounts is not taxed until you withdraw the funds. A Roth IRA, on the other hand, is taxed when it's funded—meaning you don't pay taxes on it when you retire.1 Other types of accounts, such as brokerage accounts or high yield savings accounts, may have capital gains taxes to consider.
Remember that the more you withdraw when you retire, the higher your tax rate could be. Before retiring, it's important to try to plan your withdrawal amounts to minimize your tax impact.
2. Take Advantage of Tax-efficient Investments
One way to lower your tax bill during retirement is to invest in tax-efficient investments. These are investment assets that have less taxes owed than other investing accounts. For example, municipal bonds are not taxed at the federal level (although they can be taxed at the state and local level and under certain circumstances).2 Qualified dividends are another type of tax-efficient investment. While ordinary dividends are taxed as ordinary income, some qualified dividends are taxed at a lower capital gains rate.3
Holding onto your investments for the long term is another way to lower your taxes. That's because you're only taxed on realized capital gains, or when you sell an investment. And if you hold onto your taxable assets for at least a year or longer, you can benefit from the long-term capital gains tax rate, which is lower than the standard rate. You can also offset your capital gains with any capital losses you experienced in your investments.4
Diversifying your investments across different types of tax treatment accounts can give you more flexibility when you start to withdraw your retirement savings. For example, having a tax-deferred IRA and a Roth account can give you more options when it comes to tax time.
3. Manage Your Tax Bracket
Your tax bracket during retirement can fluctuate depending on how much of your retirement savings is taxed as income. The U.S. has a progressive tax system, meaning your tax rate increases as your taxable amount rises.
The same tax brackets that apply to all taxpayers also apply to retirees. Your tax bracket will depend on your filing status and taxable income, such as your IRA and 401(k) distributions, investment income, Social Security benefits and some pension income.
You can lower your tax bill by looking at tax deductions, such as donations, and timing your withdrawals strategically. If you withdraw a large portion of your retirement savings, your tax rate will increase. Think carefully before withdrawing a significant portion of your retirement accounts.
You can also lower your overall tax bill by moving to a state with low or no state income tax. There are seven states that do not levy state income tax: Alaska, Florida, Nevada, South Dakota, Tennessee, Texas and Wyoming.5
4. Utilize Health Savings Accounts (HSAs)
As you get older, your medical expenses are also likely to increase. One way to ensure you get the care you need and keep your taxes down is to take advantage of health savings accounts. All contributions are tax-deductible, which means they can be deducted from your gross income.
The amount you can contribute each year will depend on the type of coverage you have. Contribution limits vary each year, so check with your financial advisor or on the IRS website to find out how much you can put into an HSA.
The other advantage of HSAs is that withdrawals are tax-free for eligible medical expenses, such as deductibles, copays and prescriptions.6
5. Consider Roth Conversions
You can also consider transferring your traditional retirement accounts into Roth IRAs so you won't have to pay taxes when you retire. However, you will need to pay income tax on the conversion amount when you transfer the account, but not on future accounts, as long as you wait at least five years to make withdrawals.
If your tax rate will be higher when you retire than it is today, converting your retirement accounts to Roth IRAs could make sense. Because your Roth IRAs are already taxed, it can help limit your overall tax bill during retirement.
Another advantage of a Roth IRA is that there are no required minimum distributions, which means you can withdraw as little or as much as you'd like during retirement.7
6. Plan for Required Minimum Distributions (RMDs)
Withdrawing money from your IRA and 401(k) account becomes mandatory once you reach age 72 or 73.8 When you take the money out of your account, you will need to pay income tax on it. If you don't withdraw, you'll have a penalty fee of up to 25% of the amount that should have been distributed, on top of the tax owed.9
To avoid being hit with a large tax bill, keep the RMD in mind during retirement. You can lower the taxable amount by converting your IRA to a Roth IRA, donating the money to a qualified charity or purchasing a life insurance policy for your beneficiaries.
7. Leverage Tax Credits and Deductions
While you may still have to pay taxes when you retire, you may also qualify for certain tax credits and benefits. When you turn 65, the IRS offers a larger standard deduction.10 Depending on your income level, you can also get a tax credit for contributing to a retirement account.11
There are other ways you can leverage tax deductions, such as itemizing deductions, making charitable contributions and taking advantage of tax credits like education credits and home energy credits.12 By taking time to look at all your tax credit and deduction options, you can strategize and potentially lower your tax bill.
8. Seek Professional Guidance
Taxes can be complicated. Whether you still have a few decades before you retire or you're considering retiring soon, consulting a professional tax advisor, financial advisor or financial planner can help ensure you're making the right choices for you.
A professional can recommend individual strategies that pertain to your circumstances and keep you abreast of any tax law changes.
Keep Taxes in Mind as You Prepare to Retire
As you approach retirement, remember to account for taxes. Consider ways to lower your taxes, such as converting your retirement accounts to a Roth IRA, taking advantage of tax credits and investing in long-term tax-advantaged assets like municipal bonds.
Even if you have a long time until you retire, it's never too early to start thinking about your retirement savings. Planning early and adapting your investing and tax strategies as needed can help you maximize your nest egg.
Looking to increase your retirement savings? Find out if you are on track for retirement.
Moriah Costa is a personal finance and investing writer. Her work has appeared in Thomson Reuters, S&P Global, The Washington Business Journal and others.
READ MORE: 10 Questions to Help Accurately Calculate Your Retirement Numbers
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