Creating Successful Retirement Income Strategies With Taxes in Mind

Taxes can sometimes take a big bite out of retirement income, which is why it’s so important for retirees to minimize and diversify their tax burden. Creating sound retirement income strategies requires you to plan before you cross into retirement—and to continue making smart choices once you’re there.

Here are some tax issues to consider now to ensure your future tax burden doesn’t overwhelm you in retirement.

Paying Deferred Taxes for Your 401(k) and IRA

At least a portion of many retirees’ retirement income will come from a tax-deferred account, such as a 401(k) or a traditional IRA. These accounts are a great way to build a nest egg during your career, but they can trigger a nasty tax surprise if you end up in a higher tax bracket once you reach retirement. Keep in mind that withdrawals from these accounts are taxed at the same rates as ordinary income.

In addition, the IRS requires you to withdraw certain amounts from your tax-deferred accounts when you turn 70.5 and every year thereafter, which means you may face a high tax bill at a time when you can’t afford it.

Using Roth IRAs and Roth 401(k)s

Smart retirement income strategies involve spreading out your tax payments rather than owing them all at once. Strategic investments in Roth IRAs or Roth 401(k)s are a common way to diversify retirement taxes.

Like their traditional counterparts, Roth retirement accounts offer tax-free growth. You fund these accounts with post-tax dollars and owe nothing to Uncle Sam when you withdraw your money, assuming you meet the withdrawal requirements. Roth retirement plans also have no required minimum distributions, which means you can grow your money tax free for as long as you wish.

It is possible to convert a traditional IRA into a Roth, although you will owe ordinary income tax on the amount of money you convert.

Allocating Tax-Efficient Assets

Some types of assets have higher tax burdens than others. Bonds tend to have the highest tax burden (unless they are tax free), because you are taxed at your ordinary income rate on a bond’s interest payments. Income from stocks, however, is taxed at lower, long-term capital gains rates.

If you have both tax-sheltered retirement accounts—such as traditional IRAs and 401(k)s—and taxable investment accounts, you can make the most of your money by divvying it up in the most tax-efficient way possible. This might mean placing high-yield bonds, which could potentially raise your taxes, into your tax-deferred accounts, and putting stocks and tax-exempt municipal bonds into your taxable accounts.

Strategizing After You Retire

Protecting yourself from a bigger tax bite doesn’t stop once you retire. You could, for instance, move to a state with no income tax to reduce your tax burden during your retirement years. Seven states—including Florida and Texas, which offer retirees more than just nice weather—levy no income tax on residents.

Another consideration is property tax. A savvy retiree might downsize to a smaller, less expensive house or apartment to lower their property tax burden, thereby keeping more retirement income in their pockets.

Diversify, Diversify, Diversify

No one likes to think about taxes, but understanding how they might affect your retirement income and learning to diversify is an important part of planning for your future. That way, you can live out your retirement years with minimal tax stress.

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