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5 Ways to Reduce Tax Liability in Retirement

Byline profile imageWritten by Geoff Williams
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Byline profile imageEdited by Jeff White, CEPF®
Byline profile imageEdited by Marie White, CEPF®
Updated on
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If you’re approaching retirement age, you have a lot of different things to consider. And focusing on limiting your tax liability can be especially valuable. After all, the more taxes you pay in retirement, the less money you’ll have to live off of. If you’re looking to improve your retirement situation, here are some strategies for reducing how much tax you pay in your golden years. A financial advisor can also help you refine your tax strategy and plan for retirement.

1. Remember to Withdraw Your Money From Your Retirement Accounts

It might seem unlikely that you would forget, but you do need to start withdrawing money from traditional 401(k)s and IRAs by the time you’re 73 years old. These mandatory withdrawals, known as required minimum distributions (RMDs), previously took effect at age 72. However, the RMD age increased by one year for people turning 73 in 2023 under the SECURE Act 2.0, which President Biden signed in late 2022.

You must take your RMDs by April 1 of the year after you turn 73. However, if you’re still working beyond age 73 and own no more than 5% of the company you work for, you can delay withdrawals from your 401(k) until you retire. This exception does not apply to IRAs. Starting in 2033, the age for beginning RMDs will increase to 75.

Failing to withdraw the minimum amount by the deadline will result in a 25% penalty on the amount that should have been withdrawn. That’s in addition to the income tax owed on the withdrawal, as well. To avoid unnecessary penalties and reduce your overall tax burden in retirement, it’s essential to withdraw your RMDs on time.

2. Understand Your Tax Bracket

A retiree calculates what they owe in taxes.

There’s a reason for the expression that nothing in life is certain but death and taxes. If you’re retired, there’s a good chance you’ll be paying taxes. Your Social Security benefits may be taxable if one-half of your benefits plus all of your other income, including tax-exempt interest, exceeds the base amount for your filing status, as set by the IRS:

  • $25,000 (50% up to $34,000) if you’re single, the head of a household, or a qualifying surviving spouse
  • $25,000 (50% up to $44,000) if you’re married filing separately and lived apart from your spouse for the entire year
  • $32,000 if you’re married and filing jointly
  • $0 if you’re married filing separately and lived with your spouse at any time during the tax year

The more money you report to the IRS per year, the higher your tax bracket. This can be helpful to remember if you’re withdrawing money from an IRA, 401(k) or a pension. If you’re on the edge of a tax bracket, you may want to withdraw a little less from your taxable accounts. This will enable you to remain in a lower tax bracket and reduce your tax bill. If you have a Roth IRA account, your withdrawals are tax-free.

3. Make Withdrawals Before You Need To

Some personal finance experts recommend taking smaller withdrawals from your retirement accounts in your 60s. This strategy helps distribute your tax burden over several years, potentially keeping you in a lower tax bracket and reducing your overall lifetime tax liability.

It can be a good idea to time these withdrawals during years when your income is naturally lower. For example, if you’ve retired but haven’t started receiving Social Security benefits, this period can be an ideal opportunity to draw from your retirement accounts.

3. Invest in Tax-Free Bonds

Many retirees have diversified portfolios that may include bonds, which are generally considered to be no-risk investments. You can usually invest in federal bonds and not pay state or local taxes on them (although you’ll have to report the income when you file your federal taxes). Likewise, if you purchase state or municipal bonds, you often won’t have to pay state or city taxes on the profits.

4. Invest for the Long-Term, Not the Short-term

Whether you’re trying to reduce your tax liability in retirement or before it, this might be something worth considering. If you sell an asset – like a stock, mutual fund or even a piece of art – you’ll owe a capital gains tax on the profit. How much tax you pay depends on when you initially bought the asset.

If you owned the asset for more than a year, the IRS will tax the profit at the more favorable long-term capital gain tax rate. If you sell the asset within a year of purchasing it, the sale is considered a short-term capital gain, and gets taxed as ordinary income.

For short-term capital gains, you might pay as much as 37% in 2023 or 2024, depending on your tax bracket. If you hold off and sell the asset after a year, you’ll be taxed at 0%, 15% or 20%, depending on your income level.

5. Move to a Tax-Friendly State

Some states are considered to be more tax-friendly than others, making them attractive to retirees. Alaska, Montana, Oregon, New Hampshire and Delaware, for instance, do not have sales tax.

While some states are known for low property taxes, these nine states don’t collect personal income tax:

  • Alaska
  • Florida
  • Nevada
  • New Hampshire
  • South Dakota
  • Tennessee
  • Texas
  • Washington
  • Wyoming

Then again, state laws can always change. If you love the state you live in and your family is nearby, moving to a state that collects lower taxes may not make much sense. In fact, if you move simply to escape paying higher taxes, the cost of frequent trips to visit your family in another state could negate the savings of living in a low-tax state.

Bottom Line

Thinking and investing long term can help you lower your tax liability in retirement.

When you’re retired, you’ll hopefully have investments generating income for you. However, it’s important to think about how to best preserve that income and lower your tax liability. By thinking carefully about taxes in retirement and making some shrewd decisions, you should have more money in your pockets and more breathing room so you can truly enjoy retirement.

Tips for Being More Tax-Efficient

  • Philanthropic retirees who give to charity every year may consider making qualified charitable distributions (QCDs). These payments, which come directly from your IRA, are sent to qualified charities. While they can satisfy your RMD responsibility, the QCD isn’t considered part of your taxable income and can limit your tax liability.
  • Harvesting the losses in your portfolio can help lower your capital gains tax bill and keep more of your profits. Use our Capital Gains Tax Calculator to get a sense of how much you may owe when selling an investment.
  • Need help managing your investments and optimizing your tax strategy? A financial advisor can help. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

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