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5 ways to minimize taxes on retirement income

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It’s surprising, but true – you can avoid paying taxes on a lot of your retirement income. The tax code has multiple options for legally avoiding taxes, but that doesn’t mean you can realize any level of income without paying Uncle Sam his due. If you want to reduce or even eliminate taxes on your retirement income entirely, you’ll need to carefully follow all the rules.

Below are a number of ways to avoid taxes on your retirement income, but note that most of them have a maximum amount of income that you can receive before taxes are triggered. That is, you can get some level of income tax-free, but realize too much and you’ll start to be on the hook for taxes.

1. Social Security

Yes, you can get your Social Security without paying a tax on it, but there are stipulations. Your provisional income has to stay below certain levels ($25,000 if filing as an individual, $32,000 if married filing jointly), but Social Security has a specific formula that you’ll need to check out. Don’t simply assume that you don’t qualify because your income goes above that level.

Even if you go over these levels, you may still not have to pay tax on all of your benefit, however. You may be able to scrape by with tax on only half of it or 85 percent of it.

2. Roth IRA

If you’re looking for tax-free income, the Roth IRA is your best bet and it offers a ton of flexibility, too. Any money you take out of the account in retirement (after age 59 1/2) is tax-free, provided you’ve had the account for at least five years. You won’t pay taxes on your contributions coming out of the account (since you paid taxes on them on the way in) or the earnings on the contributions, making the Roth IRA a favorite of the experts.

The Roth IRA also offers a number of estate planning benefits, and since withdrawals don’t create taxable income, you can combine it with other retirement accounts that do (such as a traditional 401(k) account), keeping your overall income inside the tax-free threshold.

3. Roth 401(k)

The Roth 401(k) offers some of the same benefits of the Roth IRA, but can be a little bit better in some circumstances and a little worse in others. Like the Roth IRA, it allows you to withdraw money in retirement (after age 59 1/2) tax-free after owning the account for at least five years.

Plus, since it’s an employer-sponsored plan, you may be able to enjoy an employer match, which gives you free money for saving for your own retirement. That said, the employer match is placed in a traditional 401(k), so you don’t get the special Roth perks for that benefit.

Where the Roth 401(k) falls a bit short of the Roth IRA, however, is that it requires minimum distributions after a certain age — which the Roth IRA does not. Those are a few of the key differences, but those considering these plans should also understand the other differences, too.

4. Traditional IRA

Yes, it’s true, money withdrawn from a traditional IRA is usually taxable if you deposited pre-tax money. However, you can wriggle out of tax if your annual income remains below your standard deduction ($12,400 for individuals and $24,800 for married filing jointly in 2020).

Admittedly, that’s not a lot of income to live on. But if you can combine a traditional IRA or traditional 401(k) with a Roth account, you can tag-team – taking income out of your traditional accounts up to the tax-free threshold and then using a Roth account to kick in tax-free income. Plan it right, and you can still get Social Security benefits tax-free, too.

5. A taxable account

If you have money in a taxable brokerage account, you’ll have to pay taxes on capital gains, but these taxes are assessed only when you sell. (You still have to pick up the tax tab on any dividends, however.) That means you can hold stocks for decades and roll up gains but never be forced to pay taxes on them. In fact, you can pass the stock to heirs, because the stock cost basis steps up to the price on your date of death, allowing heirs to avoid the tax on gains completely.

You’ll also be able to avoid taxes on your long-term capital gains, for assets held more than one year. For 2020, your long-term capital gains tax rate is 0 percent if your income is below certain levels ($40,000 as an individual filer or $80,000 as married filing jointly.)

How to max out the benefit of tax-free income

To max out these strategies, you’ll need to plan your finances ahead of time, and that could require some careful calculations.

1. Minimize the income you need

To make it easier to get tax-free income in retirement, it’s useful to live on less money. If you need less money, you won’t have to withdraw as much from your retirement accounts. This approach may mean you spend less money in retirement, but it may also mean that you’ve carefully planned your income and expenses to minimize when you’re actually realizing this income.

2. Pay off your mortgage

One good way to minimize expenses is to have your mortgage paid off before you retire. A housing payment is often a family’s single largest expense, so by eliminating it, you can drastically reduce how much income you need to realize in a given tax year. You may try the same approach with other large expenses such as a car or even a medical procedure.

If paying off your mortgage isn’t feasible, it may make sense to get a cheaper mortgage.

3. Carefully plan your withdrawals

Sometimes you may need more income and you’ll slip into a taxable bracket. That’s ok. Typically, only the portion of your income that’s above the taxable threshold will incur taxes.

For example, if your income is below the standard deduction ($24,800 for married filing jointly or qualifying widow[er] in 2020), you won’t pay federal taxes. But if you go above that level, you’ll be taxed only 10 percent on the next $19,750 of income. In other words, once you pass that first threshold, every incremental dollar of income (up to nearly $20,000) is taxed at the same rate.

With this filing status you could realize up to $44,550 in income and pay taxes of just 10 percent on the $19,750, or a total of $1,975, for an average federal tax rate of about 4.4 percent. Go over that income level, and you’ll pay 12 percent on additional income and then even higher.

If you need that taxable income, it could make sense to realize it up to the point where the tax bracket changes, and then you could slip back to the tax-free status the next year. This strategy could be prudent if it helps you avoid going into a higher bracket, 12 percent in this case.

Bottom line

Avoiding taxes entirely on your retirement income can be difficult to do, and may not be worth it, especially if you’re having to substantially curtail your lifestyle to do it. But the earlier you begin making plans – for example, with highly valuable tax-free withdrawals such as the Roth IRA and the Roth 401(k) – the more flexibility you’ll have to spend your retirement years exactly how you want them rather than worrying about taxes.

Featured image by FG Trade of Getty Images.

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Written by
James Royal
Senior investing and wealth management reporter
Bankrate senior reporter James F. Royal, Ph.D., covers investing and wealth management. His work has been cited by CNBC, the Washington Post, The New York Times and more.
Edited by
Senior wealth editor