6 of the Best Tips for Reducing Tax Liability During Your Retirement Years

A part of retirement planning that many people overlook is taxes. Failing to create a strategy for how to deal with your tax liability in retirement can result in you having to pay much more.

After retirement, tax liability changes dramatically; in general, it decreases given that there is no longer income from a full-time job. However, retirees often have income from a variety of different sources, and each is likely taxed in a different way, so it is critical to create a plan to minimize your liability.

Read on for some tips to minimize the taxes you’ll pay in retirement.

1. Open a Roth account

With traditional retirement accounts, you contribute pre-tax earnings and then pay those taxes upon withdrawal. A Roth account works in the opposite way. You contribute to the account after paying taxes on income, but then you can withdraw without paying taxes in retirement.

Some employers offer a Roth 401(k), but a more accessible option is the Roth IRA, which also can be created by converting a traditional IRA. Traditional accounts are beneficial because most people earn less in retirement and thus fall into a lower tax bracket, but having some money in a Roth account provides options for withdrawals, especially in years with a lot of income from other sources.

retirement savings

2. Diversify income sources

Once you have opened a Roth account, you have more options for how to support yourself during retirement. This means that you can stick with traditional accounts during years when you will be in a low tax bracket and then save the Roth accounts for years in which you earn more. Withdrawing from Roth accounts avoids the higher tax rate.

If your Roth accounts begin to run low, you can actually withdrawal from a traditional IRA and put the money back into a Roth account. Of course, you will need to pay taxes on the amount withdrawn, so this should only happen in low-income years and only to the extent that you are not pushed into a higher tax bracket.

3. Reduce monthly expenses

One of the best ways to reduce tax liability in retirement involves minimizing the amount of money that needs to be withdrawn from traditional retirement accounts and other sources of income. For many retirees, the largest bill that they face remains their mortgage—but you don’t want to end up making large withdrawals from your retirement account to cover the cost.

If possible, you should try to pay off your mortgage prior to retirement. It’s an especially smart move since you will likely be paying mostly on principal rather than interest by the time you reach retirement age, which limits the tax benefits received from mortgage interest deductions. If you are relocating during retirement, it also makes sense to consider cost-of-living reductions as a way of minimizing monthly expenses.

4. Invest in municipal bonds

Many retirees choose to invest in bonds as a way of supplementing their monthly income with guaranteed payments. Municipal bonds are an especially good choice since they are generally tax-exempt, which means that you will not pay federal tax on them. Also, many states do not tax income from municipal bonds. Since municipal bonds tend to have little risk involved, they pay a fairly low interest rate, so other options may be more appropriate for some retirees.

Moreover, retirees will need to include municipal bond income for Social Security tax purposes, so there may be some liability involved. However, these bonds can play an important role in a retirement investment strategy.

5. Make use of an HSA

Retirees who have a high-deductible health insurance plan will benefit the most from a health savings account (HSA). You can open an HSA as long as you have a deductible of at least $1,350 for an individual or $2,700 for a family.

medical information

Once the account is opened, you can put money into the account before you pay income tax on it. While it is in the account, the money grows tax-deferred. Then, as long as you use the funds to pay for qualified health costs, you do not pay taxes on it— even upon withdrawal.

In 2019 the HSA contribution limits are $7,000 for a family and $3,500 for an individual. For retirees, an HSA is a great way to limit tax liability when healthcare costs are high.

6. Understand Social Security tax

In retirement, you will need to pay taxes on Social Security benefits. These benefits are taxed at different rates depending on what is called provisional income, or income that is not from Social Security. Individuals who make less than $25,000 per year or couples with less than $32,000 per year will not be liable for any tax on their Social Security benefits.

For an individual making between $25,000 and $34,000 and couples making between $34,000 and $44,000, only 50 percent of the benefits are taxed. Above those upper limits, 85 percent of benefits are taxed. Importantly, married couples who file separately will automatically get 85 percent of their benefits included as gross income.