7 Ways to Reduce Tax Liability in Retirement

There’s a lot to consider as you approach retirement age, and taxes may be near the top of the list. 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 financial situation, here are some strategic ways to reduce tax liability in retirement. A financial advisor can also help you refine your tax strategy and plan for retirement.

1. Take Required Distributions on Time

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.

What you should know:

• You must take your RMDs by April 1 of the year after you turn 73. 
• 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.

What happens if you don’t take RMDs on time? Failing to withdraw the minimum amount by the deadline will result in a 25% penalty on the amount that should have been withdrawn. You’ll also owe income tax on the distribution. All of that adds up to a solid incentive to take your RMDs on time to reduce your tax liability in retirement.

2. Understand Your Tax Bracket

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.

For individual filers:

• No tax on up to $25,000
• Up to 50% of benefits may be taxed for income between $25,000 and $34,000
• Up to 85% of benefits may be taxed for income above $34,000

For married couples:

• No tax on up to $32,000
• Up to 50% of benefits may be taxed for income between $32,000 and $44,000
• Up to 85% of benefits may be taxed for income above $44,000

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, or increase deductions. 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.

4. Invest in Tax-Free Bonds

Many retirees have diversified portfolios that may include bonds, which are generally considered to be less risky than stocks.  Tax exempt bonds allow you to keep some of your retirement savings invested, while enjoying some growth and tax benefits. 

Types of tax exempt bonds include:

• Municipal bonds
• U.S. Treasuries
• Certain U.S. government agency bonds

You’ll need to report bond interest earned on your federal tax form when you file, though the type of bond can determine whether that interest is taxable. If you hold taxable bonds in your portfolio, consider the timing of when you sell those investments to minimize what you pay in capital gains tax.

5. Invest for the Long-Term

A capital gain occurs when you sell an asset for more than what you originally purchased it for. How much tax you pay depends on when you initially bought the asset.

• Short-term capital gains tax applies to investments held less than one year.
• Long-term capital gains tax applies to investments held more than one year. 

For short-term capital gains, the tax rate is the same as your ordinary income tax rate. So, you might pay as much as 37% in 2025, depending on your tax bracket. If you hold off and sell the asset after a year, however, you’ll be taxed at 0%, 15% or 20%, depending on your income level.

6. Move to a Tax-Friendly State

If you have the means to do so, you may consider moving to a state that imposes a lighter tax burden on its residents. Alaska, Montana, Oregon, New Hampshire and Delaware, for instance, do not have sales tax, which can save you money on day to day needs, like groceries or household items. 

While some states are known for low property taxes, others don’t collect personal income tax Here are some of the best states to retire for taxes:

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

If you’re contemplating a move, consider the overall cost of living in the state, not just the tax outlook. Florida, for example, has no income tax but its cost of living is 3% higher¹ than the rest of the U.S. The Sunshine State is also experiencing an insurance crisis², leaving many homeowners to forego coverage on their homes or pay exorbitant rates. Looking at the full picture can help you decide whether the tax benefits a state offers could merit a move.

7. Convert to a Roth IRA Gradually

A Roth IRA conversion makes it possible for people to contribute to a Roth account when they would otherwise be ineligible. Conversions open the door to tax-free withdrawals in retirement, but they aren’t tax-free. If you’re moving traditional IRA dollars to a Roth account, you’ll pay taxes on the earnings at the time of the conversion. 

That could lead to a sizable tax bill if you’re converting all of your savings at once. Gradual Roth conversions allow you to move your savings a little at a time so any tax liability that’s created is manageable.

This strategy is especially useful in the early years of retirement when income may be lower and before you begin collecting Social Security or taking RMDs. In addition to reducing future taxable income, smaller traditional account balances may lower your exposure to the Medicare income-related monthly adjustment amount (IRMAA) and reduce how much of your Social Security income is subject to tax.

Here’s one more benefit: Roth accounts also offer flexibility with no RMDs during your lifetime, which can help with estate planning and passing assets to heirs tax-free under current law.

Bottom Line

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 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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