How to Minimize Tax Liability After Retirement

How to Minimize Tax Liability After Retirement

Everyone hopes for a peaceful, easy retirement.

Philosopher Henry David Thoreau’s advice on achieving the uncomplicated life we normally associate with retirement was “Simplify, simplify, simplify.”

Thoreau complained that our life “is frittered away by detail.” His advice: “Let your affairs be as two or three, and not a hundred or a thousand.”

Thoreau was a man of modest means. He lived a simple day-to-day existence off the land and in a cabin. As a follower of Transcendentalism, he didn’t care much about creature comforts and security. In fact, Thoreau said, “Wealth is the ability to fully experience life.”

But life in 1850 Massachusetts was far simpler than in 21st century America. We are living longer and things are far more expensive.  We can look forward to living well into or past our 80s. Thoreau died in 1862 at age 45. So, he didn’t have tons of time for walks in the wood contemplating nature or enjoying the second chance at parenthood that having grandchildren brings. 

Also, Thoreau spent a night in jail for refusing to pay a poll tax. This was Thoreau’s gesture of civil disobedience against the legal institution of slavery and the U.S. war with Mexico. The sheriff released Thoreau after an anonymous donor paid Thoreau’s tax bill.

When it’s our time to head for the simpler life with the aid of our nest egg, our modern-day IRS “sheriff” begins zeroing in on our retirement financial resources with a tax collection code and enforcement authority that would shock Thoreau, like:

You pay income tax on your Social Security benefits.

Considering that you already donated 6.2% of you working life pay to your Social Security coffer, the income tax on what you draw out of that fund is truly a double whammy.

If you have other retirement income sources, you can plan on returning some of that Social Security money in income taxes.

Your Traditional IRA is subject to income taxes.

…And you must begin withdrawing the funds by age 70.5. The money you deposited in a Traditional IRA was subtracted from your taxable income. When you withdraw the money, both your initial investment and the interest it earned become part of your tax obligation. There are other tax penalties, with a few hardship exceptions, for early withdrawal.

Your annuity and 401(k) distributions (payouts) are also taxed. Your annuity savings were a handy hedge against taxes.

When you retire you can augment your retirement income with monthly distributions. Taxation rules on annuity payments are somewhat complicated, depending on the type of annuity and how it was set up.

The rule of thumb, however, is that you must pay income taxes on the interest the annuity earned throughout its lifetime. The tax-free part of the annuity is the original principal (or investment) in the annuity plan. (On the other hand, a 401(k) distribution is fully taxable, because you built it with pre-taxed dollars.)

Lowering Your Retirement Tax Bite

Our defense against all that taxation? “Diversify, diversify, diversify.”  Even with all your great planning, you still might have to return at least 12% in federal income taxes. So, consider the following strategies in diversifying your retirement portfolio to lower your tax obligations:

1. Invest in a Roth IRA.

Contrast the Roth to the regular IRA:

  • Investments in a Roth IRA are through after-tax dollars. Dividends, interest earnings, and subsequent increases in the value of the Roth IRA are not taxed.
  • You can still maintain your IRA past age 70.5, and, with certain restrictions, continue contributing to your account.

See this online article on how to convert a Regular IRA to a Roth IRA.

2. Set aside some of your assets as regular savings.

Savings accounts are FDIC protected. Since current interest rates on savings are low, the earnings don’t generate a significant income tax liability. Their main advantage is that the funds are immediately available for emergency withdrawal without tax penalties. (Take money out of an IRA, and you will be slammed with a 10% tax penalty.)

3. Pay off your home mortgage.

When you sell your home for retirement downsizing, your profit up to $250,000 ($500,000 for joint filers) is tax exempt.

There are, of course, ancillary tax benefits to selling your large home and downsizing to smaller digs–your property taxes and utilities costs, to name just two.

Finally, read all about what seniors should know in retirement tax planning. 

Download IRS Publication 554, Tax Guide for Seniors.

To a richer life,

Nilus Mattive

— Nilus Mattive
Editor, The Rich Life Roadmap

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Nilus Mattive

Nilus is the editor for the daily e-letter The Rich Life Roadmap and a Paradigm Press analyst.

Nilus began his professional career at Jono Steinberg’s Individual Investor Group, where he published his original research through a regular investment column. Later, he worked for a private equity business and spent five years editing Standard and Poor’s...

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