How to Reduce Your Taxable Income in Retirement

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 what you owe in taxes 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. Thankfully, a well thought out financial plan during your working years that leverages different tax-advantaged retirements savings options can help you lessen the tax burden on your retirement income. And, with some careful planning and thoughtful decision-making, there are some tax planning strategies you can use in retirement to reduce what you’ll owe in taxes.  

How taxes work with retirement income  

Like when you were working, what you owe in taxes in retirement will be based on your taxable income. However, rather than receiving a paycheck from an employer, you’re likely now getting your income from sources like qualified retirement accounts (a 401(k) or IRA), a pension, investment income or Social Security. Different types of retirement savings are taxed differently, but ultimately, you’ll likely still need to pay income tax on a portion of this income.  

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

Things start to get a little bit 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 as you cross into higher tax brackets.  

Where some strategy comes in is deciding how much income to take from different sources—and when—to stay within a certain tax bracket and keep more of your dollars. S o, for example, depending on your financial needs for the year, you may withdraw more money from your 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 be a helpful way to help you make good, educated financial decisions in retirement. An advisor can help you optimize your income strategy in retirement and minimize the impact of taxes.  

How to reduce your taxable income in retirement 

If you’re looking for tips on how to avoid paying taxes, the unfortunate reality is: there’s no way to get out of paying taxes completely. But there are some tax planning strategies you can incorporate into your financial plan that could reduce how much you’ll owe on your retirement income.  

Plan ahead 

Thinking about these things ahead of time can give you the runway you need to really make a difference when it comes to retirement. If you’re not yet nearing retirement, it may seem far off, but it’s critical to think about your retirement in 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 will probably do a lot of heavy lifting for you if you start early on, so make sure you’re taking advantage of retirement savings options available to you.   

If you’re in retirement, even looking out a year at a time can give you more runway to make decisions that benefit your tax situation.  

Include a Roth account in your plan 

Traditional 401(k)s or IRAs can be great vehicles for growing larger sums of money, but because you don’t pay tax when you contribute funds, you’ll need to pay taxes on your funds when you withdraw them in retirement. Including a Roth option—which is taxed at the time of contribution and withdrawn tax-free—can be a great way to diversify your retirement savings. Any Roth income withdrawn in retirement will not be taxed, so it can be a great tool in managing your taxable income in retirement. For instance, you might withdraw from taxable sources up to where you’d cross into a higher tax bracket. At that point, you’d switch to taking money from your Roth account.  

Time your investment decision-making 

If you’re getting income from selling investments, you’ll likely be subject to capital gains tax. How much you’ll owe will depend on how much you’ve made and how long you’ve held an asset. Generally, you’ll pay less in taxes on an asset you’ve held longer vs. an asset you’ve held for less than a year. So, holding on to investments can work to your benefit when it comes to taxes.  

However, investment decisions are largely driven by market performance and your risk tolerance. So, if you’ve decided it’s time to sell an investment, you could also sell off another investment at a loss in the same tax year to deduct a portion of those losses and offset what you’ll owe in capital gains tax—a strategy known as tax-loss harvesting. Tax-loss harvesting allows you to use losses to offset gains and up to $3,000 in ordinary income if your losses exceed your gains.  

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, which reduces what you’ll owe in taxes that year.  

Stay on top of required minimum distributions 

Starting April 1 after the year in which you turn 73, the IRS requires that you start taking required minimum distributions (RMDs) from any traditional (non-Roth) retirement savings accounts. (And in a few years, the minimum RMD age will increase to 75.) If you don’t stay on track with these deadlines, 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 will want to work with your advisor to stay on top of.   

Move to a tax-friendly state 

Besides federal income tax, it’s important to take into account the potential savings that come at the state level. Different states have different tax laws, so depending on where you live, your retirement savings could be taxed differently at the state level. For example, Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming currently do not charge income tax. (New Hampshire also doesn’t charge state income tax but does charge tax on interest and dividends.) And four additional states—Illinois, Iowa, Mississippi and Pennsylvania, do not charge taxes on retirement income. So, 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. So, if you’re earning a pension in a high-tax state like California and you 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.  

Give to charity 

Donating to charity can be a great way to put your legacy to good use, but it also has some tax benefits. But if you are 70½ or older,  a donation made directly from your IRA to a qualified charity, known as a “qualified charitable distribution” (QCD), can satisfy RMDs, and it does not count toward your taxable income in the year of the donation. Or, with a charitable gift annuity, you can purchase an annuity through a charity, giving you guaranteed income for life with reduced taxes and tax deductions in the year of your donation.  

Even just donating to a charity can help reduce your taxable income. Depending on your situation, you may be able to deduct up to 50 percent of your adjustment gross income each year.  

Be strategic with when to take Social Security 

Social Security is taxed differently  than other retirement income sources, but you won’t have to pay tax on the full benefit amount. Depending on your situation, you’ll likely need to pay taxes on 50 – 85 percent of your Social Security income. (And if you make below a certain threshold, you don’t need to pay taxes on your benefit at all.) How much is taxed also depends on your other income, which is another reason why keeping your eye on the big picture is so important.  

How much you’ll get in Social Security  depends on when you begin to take Social Security, and by delaying taking your benefit, you could earn up to 24 percent more than you would if you took it at full retirement age. And 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.  

Regularly consult with financial professionals  

As you can see, there are a lot of moving pieces when you reach retirement. This can be a lot to keep track of on your own in a time that you were hoping to kick back and relax. Working with a financial advisor and tax planner to inform these decisions can help you make strategic moves without sacrificing hours of time to educate yourself.  

And, even in retirement, life can change. You may experience life events—like deciding to go back to work part-time or increased healthcare costs—that can impact your tax circumstances. Tax laws also change. Regularly consulting with a financial advisor can help you stay on top of these changes and keep your plan on track.  

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, then design a plan that helps you reach those goals most efficiently. Then 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—that can give valuable advice about decisions that impact your tax bill.