People usually start thinking about taxes in February and forget about them completely once their return is filed a month or two later. If you want to minimize your tax liability, though, it is important to keep taxes in mind year-round. This is especially important during retirement when you are drawing down your accounts instead of building them up. Here are five ways to save on taxes in retirement.
Limit Your Exposure To The 3.8% Medicare Surcharge Tax
There is a 3.8% Medicare surcharge tax that applies to net investment income for singles with a modified adjusted gross income (MAGI) of over $200,000 and couples with a MAGI over $250,000. The MAGI is adjusted gross income with some deductions added back in, such as tax-free foreign income, IRA contributions, and student loan interest. The surcharge tax is due on the smaller of net investment income (which includes interest, dividends, annuities, gains, passive income, and royalties) or the excess of MAGI over the thresholds.
If your MAGI is near or above the thresholds, there are steps that you can take to limit your exposure. First, you will want to review the tax efficiency of your investment holdings. It may be worthwhile to move less efficient investments into tax-deferred accounts and capitalize on tax-loss harvesting. Other moves you can make include investing in municipal bonds whose interest is tax-free and taking capital losses to offset gains. Installment sales can spread out large gains and minimize your adjusted gross income, and real estate like-kind exchanges can also defer gains and their taxability.
Utilize Roth IRA Conversions
Distributions from Roth IRAs are tax-free, so they are a great tool to have in retirement. However, many people cannot contribute directly to a Roth IRA because of income limitations. Instead, you have to convert traditional IRA funds to a Roth account by paying the related income taxes. You can take advantage of low income years, such as when you have stopped working but are not yet collecting Social Security, to convert your funds to a Roth IRA so that you will have tax-free income later. It is important to be mindful of tax brackets when you do conversions so that you don’t inadvertently push yourself into higher tax rates.
Take Advantage Of The 0% Rate On Long-Term Capital Gains
If the Medicare surcharge tax is irrelevant to you because your income is much lower, then you may be able to take advantage of the 0% long-term capital gains rate. Profits on the sales of assets owned over a year are tax-free if your income is below $40,000 for singles or $80,000 for married couples filing jointly. Once you exceed those thresholds, long-term capital gains are taxed at 15% until your income gets above $441,450 for singles or $496,600 for couples, at which point the tax rate is 20%.
Claiming more deductions or making deductible IRA contributions can help to keep your income within the 0% capital gains tax range while also providing their usual tax benefits. However, you will want to be strategic about taking tax-free gains as they can raise your adjusted gross income and affect the taxability of your Social Security benefits. Also, taking those gains may incur state tax liabilities as well.
Be Strategic About Inherited IRAs
At the beginning of the year, the laws surrounding IRAs inherited by non-spouses changed. You no longer have to take out a specific amount of money from the account each year, but you do have to empty the account within 10 years. If you fail to be strategic about withdrawals, you could be forced to empty the entire account at once with 10 years’ worth of growth. The problem with that is that it would greatly increase your taxable income for the year, pushing you into higher tax brackets and subjecting you to added taxes, like the Medicare surcharge tax. If you inherit an IRA from someone other than your spouse, you need to be strategic about your withdrawals and time them so as to limit your tax liability.
If you are charitably inclined, one of the best ways to save on taxes is through donations. You can get a tax deduction on donations up to 60% of your adjusted gross income. If you have appreciated assets, you can get an even greater tax break. When you donate an appreciated asset that you have owned for over a year, such as stocks, to a charity, you do not have to pay capital gains taxes on the appreciation, but you still get to claim the full value for your deduction. This allows you to avoid the capital gains tax altogether. If your assets have declined in value, it is best to sell them yourself and donate the proceeds so that you can claim the loss when filing your taxes.
Another strategy to consider is the use of a charitable lead annuity trust. These trusts pay an annuity to a charity for a set term. When the term is over, the trust is paid out to the donor or other beneficiaries. This allows you to take an up-front write-off that can help offset other income, such as from a Roth IRA conversion or withdrawal from an inherited IRA.
How I Can Help
As you can see, there are steps that you can take to minimize your tax burden in retirement. Yet, as with most things tax-related, there are a lot of different factors to consider in order to execute these strategies properly. If you are considering these strategies, it would be wise to partner with an experienced financial advisor that can help you navigate all of the details.
If you don’t already have a trusted advisor, I would love to have a conversation with you to see how I may be able to help. You can schedule an appointment here or call me at (949) 631-3840 x2 or email email@example.com. I look forward to speaking with you!
About Jim Peters
Jim Peters is an independent financial advisor and the founder of Grace Wealth Management Group, Inc., a full-service financial firm committed to helping people pursue their financial goals. With more than 24 years of experience in the industry, Jim combines his extensive knowledge with his genuine interest in helping people pursue financial independence. Beyond his experience, he is certified as both a Chartered Life Underwriter® (CLU®) and Chartered Financial Consultant® (ChFC®), meaning he has advanced training and knowledge in financial planning and insurance. Based in Irvine, California, Jim specializes in working with individuals, families, and businesses throughout Orange County. To learn more, connect with Jim on LinkedIn or visit www.financialadvisorirvine.com.