Tax Strategies for Your Retirement Income

When you retire, your income usually flows from three sources: Social Security benefits, distributions from IRAs and retirement plans, and funds from savings and other investments (for instance, dividends, cashed-in CDs and gains from the sale of securities and other property). Depending on your income level, you may want to use certain tax strategies for your advantage. Here are a few to consider.

One of the best strategies for saving taxes on retirement income is to live in or move to a state that is tax-friendly. This will be especially important in 2018 through 2025 when only a total of $10,000 in local property and state and local income or sales taxes will be deductible for federal income tax purposes. Seven states have no income taxes: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. New Hampshire and Tennessee only tax interest and dividends; starting in 2022, Tennessee will join the list of states with no taxes.

States are barred by federal law from taxing residents on retirement benefits earned in another state. So, for example, earning a pension in California or New York (high tax states) and relocating in retirement to Florida or Texas (no tax states) avoids state tax on this income.

Other states may have low income taxes (see information about this from the Tax Foundation) or special breaks for retirement income. For example, states may have no tax on Social Security benefits, and on some or all of the income from IRAs and retirement plans. 

You may want to change your investment holdings in retirement – not only to preserve principal, but also to save on taxes. 

• Municipal bonds. Interest on these bonds is free from federal income tax, although the interest may impact the tax on Social Security benefits.
• Dividend-paying stocks. If you receive “qualified dividends” (essentially regular dividends from publicly traded U.S. corporations, as well as certain foreign corporations), they are taxed at more favorable rates than ordinary income. The tax rate may be zero, 15% or 20%, depending on your taxable income.
• Take losses. You can use losses on the sale of securities and other property to offset capital gains, so that you pay no tax on the gains. What’s more, if you have excess capital losses, you can use up to $3,000 to offset ordinary income (for example, bank interest) and any additional losses can be carried forward.

If you are at least 70½, you do not have to pay tax on required minimum distributions (RMDs) from your IRA if you transfer the funds to a charity. Here’s what’s required:

• Your IRA trustee or custodian must transfer the funds directly to an IRS-approved public charity.
• You must receive a written acknowledgment from the charity as you would for a charitable contribution.

There’s a $100,000 annual limit for this strategy. If you are married, each spouse has a separate $100,000 limit. This strategy can only be used for IRAs, not for IRA-like accounts such as SEP-IRAs or SIMPLE-IRAs.

(For more on this strategy, see How to Use the QCD Rule to Reduce Your Taxes.) 

You can also postpone the need to take RMDs and ensure that you won’t run out of retirement income by investing in a special deferred annuity. You can use up to $125,000 (but no more than 25% of your account balance) from your IRA or 401(k) to buy a qualified longevity annuity contract (QLAC) within the retirement account. Funds allocated to the QLAC are exempt from RMD calculations. Payments from a QLAC do not have to begin immediately, but must start no later than age 85. The payments are taxable to you, and the funds from the QLAC automatically satisfy RMD requirements for this portion of the IRA or retirement plan.

But consider the drawbacks to a QLAC before proceeding. There is no cash value that can be tapped before annuitizing. There may be higher fees for this type of investment than others available through an IRA or 401(k) plan. And you must live to the targeted age (e.g., 85) to enjoy the income.

If you don’t need the benefits at full retirement age (currently 66) because you have other income, consider delaying the receipt of benefits until age 70. You’ll earn additional credits to boost your monthly benefits at that time, and you won’t have to pay taxes now on the benefits.

When you receive benefits, they are fully tax-free or includible in your gross income at 50% or 85%, depending on your other income (including tax-free interest on municipal bonds). More specifically, if your provisional income (a term unique to the calculation of the taxable portion of Social Security benefits) is less than $25,000 if you’re single, or $32,000 if you’re married filing jointly, then none of your benefits are taxed. But if your income is between $25,000 and $34,000 if single, or $32,000 and $44,000 if you’re married filing jointly, then 50% of benefits are taxable. Having income over $34,000, or $44,000 respectively means benefits are 85% included in gross income. Married persons filing separately automatically have 85% of benefits included in gross income. (For further reading, see Are My Social Security Benefits Taxable?) 

Because the portion of Social Security benefits that is taxable depends on your other income, control this to the extent possible. Some ideas:

• Reduce your adjusted gross income. You can do this by contributing to deductible IRAs and 401(k) plans if you are still working.
• Control the sale of securities. While sales should primarily be dictated by financial considerations, where you can you may want to limit sales so that your income doesn’t push you over the 50% inclusion to the 85% inclusion.
• Use Roth IRA funds. The funds from a Roth IRA are not taken into account in the computation of the tax on Social Security benefits.

Paying attention to tax strategies for your retirement income is important, but there is no single right strategy. Each person’s personal situation is different and a tax strategy needs to be customized for you. Talk with your tax or financial advisor to learn more.