Why Tax Planning is Crucial for Maximizing Your Retirement Savings?

While some federal and state laws provide special tax benefits for retirees, most of your retirement income, from Social Security benefits to withdrawals from 401(k)s or traditional Individual Retirement Accounts (IRAs), can still be taxed. Your Social Security benefits, for instance, are taxed depending on your income level. Additionally, investment earnings from dividends, interest, and rental income outside of your retirement accounts will be taxed as ordinary income. Ordinary income tax rates can reach as high as 37% as of 2024. Even the gains from selling your investments, also known as capital gains, are taxed at short- and long-term capital gains. It suffices to say that retirement tax planning is essential to ensure your income is not lost amongst these taxes.

A financial advisor can guide you through tax planning for retirement. This article will also cover some effective retirement tax strategies to help you minimize your tax liabilities in retirement.

Why is tax planning for retirees important?

Retirement and tax planning are two peas of the same pod. Practically everything that you earn through your investments will be taxed in retirement. You may also owe taxes on things you own, such as your home. This makes it essential to implement suitable tax strategies that can help you lower your taxes. Here’s a look at why tax planning is so important in retirement and the specific ways taxes can affect your income:

1.Required Minimum Distributions (RMDs): One of the biggest tax surprises for many retirees is the requirement to take Required Minimum Distributions (RMDs) from tax-deferred retirement accounts like the traditional 401(k). Starting in 2023, the SECURE 2.0 Act pushed the age for RMDs to 73. So, if you turn 72 in 2023, you do not need to start taking distributions until April 1, 2025, for the 2024 tax year. Even if you do not need the money, you still have to withdraw a set amount each year and subsequently pay income tax on it. The amount of these RMDs is based on life expectancy tables, which can lead to sizable mandatory withdrawals per annum. These distributions can push you into a higher annual tax bracket without proper retirement tax planning. Here are the federal tax brackets for the 2024 tax year, which are applied to all your income:

2. Capital gains taxes on investment income outside retirement accounts: Retirees also have other taxable investments, such as stocks, bonds, rental property, etc. Investment income, including dividends, rental income, and interest, is taxed as ordinary income, with rates ranging between 10% and 37%. So, the higher you earn, the more tax you pay.

3. Capital gains taxes: Capital gains that you earn on the sale of different investments are also taxed. Short-term capital gains earned on assets held for less than a year are added to your annual income and taxed according to the ordinary tax rates mentioned above. Long-term capital gains on assets held for more than one year are taxed at different rates, as explained below:

4. Taxation of Social Security benefits: Social Security benefits may be subject to federal income tax. Your overall tax liability depends on your total income, which includes half of your Social Security benefits. Here’s how it works:

• For single filers with a base income over $25,000, up to 50% of Social Security benefits may be taxed.
• For married couples filing jointly with base incomes over $32,000, up to 50% of benefits may be taxable.
• If base income exceeds $34,000 (single filer) or $44,000 (married filing jointly), up to 85% of Social Security benefits may be subject to tax.

5. State and local sales taxes: State and local taxes can also affect retirees. States differ in how they apply taxes, so where you live matters. Certain states still impose state income tax on Social Security benefits. These states include Connecticut, Colorado, Kansas, Minnesota, Montana, New Mexico, Rhode Island, Utah, and Vermont.

6. Net Investment Income Tax (NIIT): The Net Investment Income Tax (NIIT) is a 3.8% surtax that applies to certain types of investment income if your income exceeds specific thresholds. Net investment income generally includes different sources of money like interest, dividends, and capital gains, as well as income from passive sources like rental properties. Here’s how this is levied:

• For single filers, the NIIT applies to net investment income if your Modified Adjusted Gross Income (MAGI) is over $200,000.
• For married couples filing jointly, the limit is set at $250,000.

7. Property taxes on your home: Property taxes are typically based on the value of your home. The rates may vary significantly depending on the state in which you reside. Property taxes may increase if the value of homes increases in your area.

8. Sales taxes on purchases: Sales taxes can be a significant expense in retirement. These taxes are applied to your purchases, including essentials and non-essentials. State sales tax rates can differ widely across the country, but they generally range from 2.9% to 7.25%.

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Tax strategies for retirees to maximize retirement income

1. Claim the standard deduction

Each year, the IRS allows taxpayers to either itemize their deductions or opt for a standard deduction. Itemized deductions require you to submit a detailed record of qualifying expenses. On the other hand, the standard deduction deducts a fixed amount based on your filing status and, in some cases, your age or disability. Choosing the standard deduction can help lower your taxes in retirement, especially if you do not have enough qualifying expenses for itemized deductions. The standard deduction values are adjusted for inflation every year. Here are the thresholds for 2024:

• Single filers can claim a standard deduction of $14,600.
• Taxpayers who are married and filing jointly have a higher deduction of $29,200.
• For head-of-household filers, the deduction is $21,900.
• Married taxpayers who are filing separately can claim a standard deduction of $14,600.

It is important to note that the standard deduction is only available to filers who do not itemize their deductions.

An additional benefit comes into play for those aged 65 or older as of 2024:

• Seniors aged 65 or more filing as single or head of household can increase their standard deduction by $1,950, bringing their total deduction to $16,550 for single filers and $23,850 for head-of-household filers.
• For married couples filing jointly, each spouse over 65 can add $1,550 to their standard deduction, raising it to $30,750.

The IRS also offers an extra deduction for those who are blind. If you or your spouse are legally blind by the last day of the tax year, you can increase your standard deduction even further. However, if you are claimed as a dependent on another taxpayer’s return, the standard deduction is limited to a minimum of $1,300 or your earned income plus $450, whichever is greater.

2. Keep a balance of tax-deferred and tax-free retirement accounts 

Retirement accounts generally fall into two categories – tax-deferred and tax-free. Both types have unique benefits and combining them together can help you with retirement tax planning. Tax-deferred accounts, like traditional IRAs and 401(k)s, allow you to contribute your pre-tax income, which lowers your taxable income in the year you make the contribution. However, you are supposed to pay income taxes when you withdraw these funds in retirement. Many employer-sponsored plans, such as traditional 401(k)s, fall into this category. Hence, you will face some tax obligations on withdrawals in retirement. On the other hand, tax-free accounts like Roth IRAs allow for after-tax contributions, so the money grows tax-free, and withdrawals are also tax-free in retirement.

While it may be challenging to rely solely on tax-free accounts due to income limits and contribution caps that come with them, adding a Roth IRA to your retirement portfolio can offer distinct advantages. With a mix of both types of retirement accounts, you can create a tax-diverse income stream in retirement. This strategy allows for flexibility in how much of your income is taxed. Additionally, Roth IRAs are not subject to RMDs, which helps your money to grow tax-free as long as you want and withdraw your funds only when it suits your needs.

3. Evaluate the years you will be in a lower tax bracket and take advantage of those

Evaluating the years when you will be in a lower tax bracket can be one of the most efficient tax saving strategies for retirees to help you maximize your retirement savings. Planning ahead can help you manage your long-term capital gains, RMDs from retirement accounts, and Social Security benefits.

Let’s consider the example of capital gains taxes. If you are married and filing jointly with a taxable income of up to $94,050, your long-term capital gains tax rate is 0%. For incomes between $94,051 and $583,750, this rate increases to 15%. All you have to do is keep an eye on your income levels each year, and you can strategically plan when to sell your investments. Keeping these transactions within the lower tax brackets will help you earn profits while keeping your taxes minimal. This can be especially useful if you are in a period of lower income, such as early retirement, before your RMDs and Social Security benefits begin.

When it comes to RMDs, which are mandatory from traditional retirement accounts beginning at age 73 as per SECURE Act 2.0 adjustments, you can consider planning your distributions carefully. RMDs are treated as ordinary income, and if you withdraw too much from your traditional IRAs or 401(k)s, these mandatory withdrawals can push you into a higher tax bracket. You might consider drawing money from your other investments, such as tax-free Roth IRAs, to balance out your income. Additionally, you must also be thoughtful about your Social Security planning. Although you can start taking Social Security benefits as early as age 62, delaying them increases your monthly benefit. For example, if you were born in 1960 or later, your full retirement age is 67. If you delay your benefits till 67, you will receive 100% of your calculated monthly benefit. However, if you delay your benefits until age 70, the monthly benefit amount will increase significantly due to an 8% annual delayed retirement credit for each year you defer beyond your full retirement age. While this may be a great strategy to increase your monthly paycheck, you must also be mindful of your taxes. The higher you earn, the more taxes you will pay. Since RMDs are taxed as ordinary income, and your Social Security benefits are also subject to taxation if your combined income exceeds certain limits, your tax rate may rise as both sources of income will be added together. So, before starting RMDs, you could consider converting some of your traditional retirement accounts, like a 401(k), to a Roth IRA. You may also withdraw just enough from your taxable accounts to meet your needs without significantly increasing your taxable income.

4. Speak to a retirement planner

Since retirement tax strategies are highly individual, it is crucial to work with a retirement planner who can tailor advice specifically to your situation. For instance, one of the key decisions many retirees face is whether to delay their Social Security benefits or claim them early. While claiming Social Security early provides you with immediate income, delaying your benefits allows you to earn a larger monthly benefit later, but it may also increase your taxes. A retirement planner can help you analyze your financial situation to determine the best strategy based on your life expectancy, other sources of retirement income, and your overall financial goals. Another critical decision is whether to convert your traditional retirement accounts, like a 401(k) or IRA, into a Roth IRA. Traditional accounts are taxed as ordinary income when you make withdrawals, whereas Roth IRAs provide tax-free withdrawals in retirement, but you would have to pay taxes on the amount you convert now. This can be a complex decision that depends on factors such as your income tax bracket in the year of withdrawal and your future retirement goals. A retirement planner can help you evaluate whether a Roth conversion makes sense for you and, if so, when and how to do it in the most tax-efficient manner.

To conclude

Make sure that you make tax planning for retirement a top priority to protect your hard-earned income from unnecessary taxes. With the right strategies, you can amplify your gains and ensure that your money is not being lost to taxes. However, before you dive into any strategy, it is essential to consult with a professional to ensure you effectively use the tax provisions available to you to reduce your taxable income.

Use the free advisor match tool to get matched with experienced financial advisors who can help you plan your retirement tax strategies. Answer some simple questions about your financial needs and get matched with 2 to 3 advisors who can best fulfill your financial requirements.

For further information on creating a suitable retirement plan for your unique financial requirements, visit Dash Investments or email me directly at dash@dashinvestments.com.

About Dash Investments

Dash Investments is privately owned by Jonathan Dash and is an independent investment advisory firm, managing private client accounts for individuals and families across America. As a Registered Investment Advisor (RIA) firm with the SEC, they are fiduciaries who put clients’ interests ahead of everything else.

Dash Investments offers a full range of investment advisory and financial services, which are tailored to each client’s unique needs providing institutional-caliber money management services that are based upon a solid, proven research approach. Additionally, each client receives comprehensive financial planning to ensure they are moving toward their financial goals.

CEO & Chief Investment Officer Jonathan Dash has been covered in major business publications such as Barron’s, The Wall Street Journal, and The New York Times as a leader in the investment industry with a track record of creating value for his firm’s clients.