8 Ways to Reduce Your Taxable Income in Retirement

Bridget F. Wall is an advanced planning attorney at Northwestern Mutual.

If you thought filing your taxes was complicated during your working years, wait until you get to retirement. There’s a lot more that goes into figuring out your tax liability when you’re drawing income from multiple sources that are taxed differently.

You’ve worked hard for those retirement savings, so it can be disheartening to send large chunks of it away to the IRS. This is why it’s so important to have a strong financial plan that leverages different tax-advantaged retirements savings options. Some thoughtful planning can help reduce the tax burden on your retirement income. Let's explore some retirement tax strategies to have on your radar.

How taxes work with retirement income

How much you owe in taxes as a retiree will be based on your taxable income. But rather than receiving a paycheck from an employer, you’ll probably be getting your income from multiple sources. That can include qualified retirement accounts like a 401(k) or IRA, a pension, investment income or Social Security. Different types of retirement accounts are taxed differently, but you’ll likely still need to pay income tax on a portion of this money.

To figure out how much you’ll owe, you can add up your taxable income from each of these sources, account for any deductions, and arrive at your total taxable income. This will determine which tax bracket you fall into, which dictates how much you need to pay in taxes.

Things start to get a little more complicated as you cross into higher tax brackets. Each time you move up, you’ll pay more tax on every dollar you take—which means you’ll have to withdraw more to get the same amount.

Being strategic means deciding how much income to take from different sources—and when to make withdrawals—to stay within a certain tax bracket. Depending on your financial needs for the year, you might withdraw more money from a Roth account, which would not count toward your taxable income, or make investment decisions that would allow you to take additional deductions on your taxes.

Regularly meeting with a financial advisor to review your situation can empower you to make educated financial decisions in retirement. They can help you optimize your income strategy as a retiree and minimize the impact of taxes.

How to reduce your taxable income in retirement

While there’s no way to get out of paying taxes completely, there are some retirement tax strategies that could reduce how much you’ll owe during this time. Here are eight ways to minimize taxes in retirement.

1. Start planning sooner rather than later

Thinking about these things ahead of time can give you the runway you need to build an adequate nest egg. Even if retirement’s a long way off, it’s critical to think about it during your working years and create a financial plan to help you get there.

A tax-advantaged retirement savings account like a 401(k) or IRA can do a lot of heavy lifting for you. The longer your money is invested, the more time you’ll have to reap the benefits of compound interest. But even if you’re feeling behind on retirement planning, the truth is that it’s never too late to start saving for the future.

If you’re already retired, even looking out a year at a time can prepare you to make decisions that benefit your tax situation.

2. Include a Roth account in your plan

Traditional 401(k)s and IRAs can be great vehicles for growing your money over time, but since you don’t pay tax when you contribute funds, you’ll need to cover it when you make withdrawals in retirement. Including a Roth option, like a Roth IRA or Roth 401(k), can be a great way to diversify your retirement savings. That’s because Roth accounts are taxed at the time of contribution and can be withdrawn tax-free. That can be a great tool in growing your wealth and managing your taxable income in retirement.

You might withdraw from taxable sources up to where you’d cross into a higher tax bracket. At that point, you could switch to taking money from a Roth account. Drawing on your nest egg in the most tax-efficient way possible is a key part of retirement planning. That’s where the tax triangle comes in. The idea is to generate retirement income from three different types of accounts:

• Tax-deferred accounts
• Tax-free accounts
• Taxable accounts

3. Time your investment decision-making

If you’re getting income from selling investments, you’ll likely be subject to capital gains tax. The amount you’ll owe will depend on how much you’ve made and how long you’ve held an asset. You’ll generally pay more in taxes on an asset you’ve held for less than a year. This is why holding onto investments can work to your benefit when it comes to taxes.

Having said that, investment decisions are largely driven by market performance and your risk tolerance. Historically, the stock market has seen positive long-term growth, but you can expect market dips along the way. Making retirement withdrawals during a down market could diminish your savings faster. This is known as sequence of returns risk, but there are potential ways to mitigate it.

If you’ve decided it’s time to sell an investment, you could also sell off another asset at a loss during the same tax year—and then deduct a portion of those losses to offset what you’ll owe in capital gains tax. This is a strategy known as tax-loss harvesting.

At the end of each tax year, your advisor can also recommend other year-end tax strategies that could impact what you’re able to deduct. That could reduce what you’ll owe in taxes that year.

4. Stay on top of required minimum distributions

When you turn 73, the IRS will require you to start taking required minimum distributions (RMDs) from tax-deferred retirement accounts. That includes traditional IRAs and 401(k)s. (FYI, the RMD age is set to increase to 75 in 2033.) If you don’t follow the rules here, you could be subject to a 25 percent penalty plus income tax on the amount you should have withdrawn. These rules are complicated, and mistakes come with a hefty penalty, so it’s something you’ll want to stay on top of. A financial advisor can help with that.

5. Move to a tax-friendly state

Aside from federal income tax, it’s important to consider potential savings at the state level. Different states have different tax laws, so depending on where you live, your retirement savings could be taxed differently. For example, a handful of states don’t charge income tax, and some don’t tax retirement income. If you move to one of those states in retirement, you’d owe less in taxes at the state level.

Federal law also prohibits states from taxing retirement benefits that you earn in another state. If you’ve earned a pension in a high-tax state like California but decide to move to Florida (a state that doesn’t charge income tax), you would not be required to pay state tax on your pension.

6. Give to charity

Donating to charity can be a great way to put your legacy to good use, and it also has some tax benefits. If you are 70½ or older, you could donate to a qualified charity directly from your IRA. This is called a qualified charitable distribution (QCD), and it will satisfy RMD rules and won’t count toward your taxable income for that year. It offers a tax-efficient way to make a charitable contribution for those who take the standard deduction. You can also consider a charitable gift annuity. This allows you to purchase an annuity through a charity, unlocking guaranteed income for life and some attractive tax perks.

Regular charitable donations can also help reduce your taxable income. Depending on your situation, you may be able to deduct up to 60 percent of your adjusted gross income each year (if you itemize and make cash contributions to public charities).

7. Be strategic on when to take Social Security

Social Security is taxed differently than other retirement income sources, but you won’t be taxed on the full benefit amount. Depending on your situation, you’ll likely need to pay taxes on 50 percent to 85 percent of your Social Security income. (If you’re below a certain income threshold, you won’t need to pay taxes on your benefit at all.)

How much you’ll get in Social Security depends on when you begin taking your benefit. If your full retirement age is 67 and you wait until age 70, you’ll get 24 percent more. The higher your Social Security payment, the less you’ll need to draw from other taxable sources, so there could be some tax savings here as well.

8. Regularly consult with financial professionals

Retirement planning has many moving parts. It can be a lot to keep track of on your own, which is why working with a financial advisor and tax planner can be so valuable. They can assess your unique financial situation and recommend strategies to maximize your savings and reduce your tax liability.

Even in retirement, life can change. You may decide to go back to work part time, or you might encounter increased health care costs—and that could impact your tax circumstances. Tax laws also change. A financial advisor can help you stay in the know and keep your plan on track.

Your Northwestern Mutual financial advisors can help you start planning from the ground up. An advisor can get an understanding of your personal situation and retirement goals and then design a plan that helps you reach those goals most efficiently. And in retirement, an advisor can help you make decisions that maximize what you’ve saved. Advisors are also well -connected to other industry professionals, like tax planners who can give valuable advice about decisions that impact your tax bill.