Strategies to Reduce Income Taxes in Retirement
A core philosophy at EntryPoint Wealth Management is to reduce our client’s income tax paid throughout their lifetimes. Advising clients on their tax situation is often considered a no-go subject in the financial industry. However, I feel the first step in providing quality advice to clients is understanding their tax situation. I grew up preparing income tax returns for individuals in a family business; during that time, I never heard anyone say they wanted to pay the government more than required. Today, I use specific tax planning software to identify opportunities for my clients to reduce their tax payments and implement strategies to build wealth.
As retirement approaches, your income and tax situation will change dramatically as you leave employment with consistent income and transition to living off your assets. Most individuals are familiar with their income tax situation, as it doesn’t change much during your working career. However, that changes once you retire, and there are many nuance strategies that knowledgeable retirees can take advantage of to increase the success of their retirement plan and lower their income tax. As a Financial Advisor focusing on helping clients near or in retirement, I incorporate these strategies whenever I see the opportunity.
Strategy #1: Delay Social Security
The most underrated strategy to reduce taxes in retirement is choosing to delay claiming Social Security benefits. By choosing to wait on your payments, you will benefit in many ways:
- You will reduce the taxation of your Social Security.
- You will reduce the taxation of your other income and Capital Gains.
- You will increase the amount of your Social Security when you choose to start your benefits later.
I have worked through many retirement income situations where clients have taken my recommendations in the peak tax planning years to save thousands of dollars in taxes by delaying social security. I have helped clients increase their income from investments, or if your taxable income is below certain thresholds, clients have sold stock and other assets, paying zero capital gains taxes. I have had clients start consulting and earning triple their Social Security income amounts, which would have triggered unnecessary taxes.
Who doesn’t want more income? Well, there are only a few times when you will have the flexibility to adjust your income to maximize your tax amount. Understanding how your Social Security Income will be taxed is a critical component to determining when to start this additional income:
- If your combined income is under $25,000 (single) or $32,000 (joint filing), there is no tax on your Social Security benefits.
- For combined income between $25,000 and $34,000 (single) or $32,000 and $44,000 (joint filing), up to 50% of benefits can be taxed.
- With combined income above $34,000 (single) or above $44,000 (joint filing), up to 85% of benefits can be taxed.
Case Study
Consider the following case study as an example of these concepts: Married couple mid-60s, transitioning to retirement. One spouse has already elected to receive social security, and the other is considering their options. Also, consider that they have assets and income to bridge the time from their mid-60s to 70 years old. These clients can take Social Security, increasing their income by $31,200 and adding $26K to their taxable income. Remember, their expenses are already met, so their lifestyle doesn’t change; however, their tax bill will increase 26% or almost $7,000 (Ohio taxes social security if the IRS taxes it). Consider the other option of waiting until 70 to take Social Security; the client delaying Social Security will receive 44,400 annually, and the other spouse’s Social Security will increase by $4200 annually through a spousal benefit. So their income will increase by $13,200 by waiting until 70 – all while saving $7,000 per year for about five years, equaling a tax savings of $35,000.
I did not “cherry-pick” these clients to prove my point. At EntryPoint, we take the time to understand all aspects of a client’s scenario to help them make the best decisions to achieve their goals. I simplified these details for this article as these clients have many other complex objectives.
Strategy #2: Using Qualified Charitable Distributions to Your Advantage
Another effective strategy for reducing taxes in retirement is to make Qualified Charitable Distributions (QCDs) from your IRA. Under current tax law, individuals aged 70½ or older can make direct charitable contributions of up to $100,000 annually from their IRA. Additionally, IRA account holders are also forced to make the Required Minimum Distributions (RMD) starting at age 73. QCDs are not included in your taxable income, which can lower your overall tax liability.
By making qualified charitable withdrawals from your IRA, you can support causes you care about while reducing your taxes. This strategy can be especially beneficial for individuals who are subject to required minimum distributions (RMDs) from their IRA, as it allows them to satisfy their RMDs without increasing their taxable income.
Most new clients I begin working with who are at this age are rarely aware that this tax strategy exists. The QCD has grown in popularity since Trump’s Tax Bill was passed in 2017, as most income tax fliers are now taking the standard deduction. Once you turn 70½, it is significantly more effective for clients to use QCDs for charitable giving than any other strategy.
Closing Thoughts
