Four Tax-Saving Strategies

Tax-Saving Strategy 1: Optimal Asset Liquidation

Timing plays a pivotal role in asset liquidation to reduce your tax burden during retirement. To benefit from favorable tax rates, you will need to leverage long-term capital gains to your advantage.

As a brief reminder, capital gains refer to the increase in value of an investment or a real estate property over its purchase price. The capital gains tax you pay on this profit varies depending on how long you have held the asset. If you sell an asset after owning it for a year or less, it’s considered a short-term capital gain, and the gain is taxed as ordinary income. This tax can be a considerable amount if you are in a higher income tax bracket. However, if you hold the asset for more than a year before selling, it is considered a long-term capital gain. Long-term capital gains are usually taxed at lower rates, which can be 0 percent, 15 percent, or 20 percent, depending on your taxable income.

There are also timing strategies during the year to consider when liquidating an asset. For instance, let’s say it’s late in the year, and you’re planning to liquidate a sizable asset that would push you into the next tax bracket if sold this year. Instead, you might decide to sell a portion this year, staying within your current tax bracket, and then sell the rest early in the following year when the tax brackets reset. This example is a simplified illustration, and the situation can be more complex in reality. As deciding to liquidate an asset has tax implications and affects your overall investment strategy and financial goals, it’s always wise to consult your tax and financial advisors.

Tax-Saving Strategy 2: Retirement Income Distribution Optimization

Our second tax-reducing strategy is to optimize your retirement income distribution. Remember, different types of accounts have different tax implications upon withdrawal.

For example, if you have three primary types of accounts — a taxable account, a traditional IRA, and a Roth IRA, when you withdraw from each, the tax consequences are quite distinct.

In your taxable account, you own assets that have appreciated over time. When you sell those assets, you will likely incur capital gains tax. However, if you’ve held these assets for over a year, they qualify for long-term capital gains tax rates, which, as we just discussed, are typically lower than ordinary income tax rates.

In your traditional IRA, your contributions have likely been made pre-tax, which means that withdrawals in retirement are taxed at your ordinary income tax rate. Depending on your overall income, these withdrawals could potentially bump you into a higher tax bracket.

Meanwhile, in your Roth IRA, because you contributed post-tax money, your withdrawals in retirement, including both contributions and earnings, are generally tax-free.

Now, let’s look at an example. Suppose you need an additional $50,000 for a major expense in retirement. If you take all of it from your traditional IRA, your taxable income for the year could increase substantially, potentially moving you into a higher tax bracket.

Alternatively, if you take a portion from your taxable account (paying long-term capital gains rates, assuming the assets have been held for over a year) and the rest from your Roth IRA (which does not increase your taxable income), you can spread out the tax impact.

The best strategy for you will depend on your specific circumstances, including your income needs, your tax bracket, your investment portfolio, and your overall financial goals.

Tax-Saving Strategy 3: Planning for Required Minimum Distributions

Required Minimum Distributions, or RMDs, are mandatory withdrawals that you must start taking from your tax-deferred retirement accounts such as 401(k)s, traditional IRAs, and other similar accounts once you reach a certain age. The current age to begin RMDs is 73, but due to recent legislation, this age is changing, so be sure to keep up with the current IRS rules, as they can change.

Planning around your RMDs can be a potent tax-saving strategy for retirees. Because these distributions are counted as taxable income, they can push you into a higher tax bracket if not strategically planned.

One of the most effective ways to optimize RMDs for tax purposes is to start withdrawals earlier than required. If you’re in a lower tax bracket in the years leading up to age 73, it could be beneficial to start withdrawals and pay tax on them at your lower rate. This strategy could reduce the size of your RMDs later, helping you manage your tax bracket in future years.

Another approach is to convert a portion of your tax-deferred accounts to a Roth IRA in the years before you must start taking RMDs. While you’ll owe taxes on the amount converted, Roth IRAs do not have RMDs, and any future withdrawals are tax-free. This strategy can help reduce the size of future RMDs and provide tax-free income in retirement.

If you have a significant amount of assets in tax-deferred accounts, you might also consider Qualified Charitable Distributions. Qualified Charitable Distributions allow you to directly transfer funds from your IRA to a qualifying charity, which count towards your Required Minimum Distributions and are excluded from your taxable income.

Remember, when it comes to RMDs, a strategic, thought-out approach can have a significant impact on your tax situation and your retirement income.

1. The Child and Dependent Care Credit

If you’re a retiree who is also caring for a dependent, such as an aging parent or grandchild, you might qualify for this tax credit. The credit gives you back a percentage of the cost you spend for necessary care up to certain limits.

2. Medical Expense Tax Credit

If you have high out-of-pocket medical expenses in any given year, you may be able to take advantage of this credit. You could deduct medical expenses that exceed 7.5% of your adjusted gross income.

3. Residential Energy Credit

If you make certain energy-efficient improvements to your home, you may qualify for this credit. It applies to qualifying projects like installing energy-efficient windows, doors, or heating and cooling systems.

It’s important to note that tax laws can be complex and change frequently, so always consult a tax professional or a CERTIFIED FINANCIAL PLANNER™ to understand how these and other tax credits could apply to your situation.

Taking the time now to identify and utilize all the tax credits available to you can significantly lower your overall tax burden and help preserve your wealth in retirement.

As we have just reviewed, you can see that taxes can significantly impact your retirement income. But with careful planning, you can manage your tax burden and potentially increase your income in retirement. A balanced approach to tax-saving strategies is crucial.

Check back for our next blog in this ongoing series, when we will discuss how to control your risk using insurance.