If you want to keep taxes low in retirement, a handful of strategies can be used while working or when retired to keep your tax bill reasonably small.
The reasons to do so may seem obvious — most people prefer to keep more and pay less in taxes — but there are some advantages to keeping your taxable income relatively low that you might not be thinking about.
Some options may seem counterintuitive. For example, it might make more sense to incur taxes in the present to avoid higher taxes in the future.
As the final deadline to pay 2022 taxes has passed even for those of us who filed an extension, let’s dig into the ways we can plan for a low-tax retirement.
If you’re a high-income earner, you’re no doubt used to paying a lot in taxes every year. There’s federal income tax, state income tax in most states, and even municipal income taxes in some cities.
Then you’ve got property taxes, sales taxes, and FICA tax, which includes both Social Security and Medicare tax.
Fortunately, some of these will shrink a lot when you retire, and some will go away completely. Without earned income, you do not pay FICA taxes. If you move somewhere with no state income taxes, you’ll be done paying those.
You’ll most likely income sources that will be subject to tax, but typically at a lower tax bracket than you’re used to, and some of that income may be in a 0% tax bracket. We’ve previously demonstrated on the blog how one can spend six figures in retirement while paying no income tax.
Here are some of the extra benefits of having a low taxable income.
0% Capital Gains Bracket
If your taxable income is $89,250 or less (for married filing jointly — divide by 2 if filing single), you won’t pay any taxes on your long-term capital gains or qualified dividends. If that’s where most of your income is coming from in retirement, you can have a very low-tax retirement with ease as long as you can stay within the boundaries.
Keep in mind that you can typically spend quite a bit more than $90,000 while still having taxable income less than $90,000. Tax diversification is key.
ACA Subsidies for Healthcare
The subsidy amount you might qualify for varies based on where you live, the size of your household, and how much income you have, but the savings on health insurance can be substantial.
I plugged in my state of Michigan, household size of 4, and found that I’d likely qualify for subsidized health insurance from healthcare.gov with income under $111,000.
Your mileage may vary, but many early retirees are savings thousands of dollars annually thanks to the Affordable Care Act subsidy.
Child Tax Credit
When you have income of $400,000 or more as a couple or $200,000 or more as a single filer, you start to lose the child tax credit of $2,000 per child for each child dependent age 17 and under.
Effectively, the loss of the child tax credit functions as a 5% addition to your marginal tax rate, where you lose $50 of the tax credit for every additional $1,000 in income until the credit is all gone. If, like me, you’re married with two children, the tax credit is eliminated at an MAGI of $480,000.
When retired, it’s likely that your adjusted gross income will be nowhere near these numbers unless you’ve got tens of millions of dollars. If you’ve got that, you need more advanced strategies to lower taxes than I can help you with!
American Opportunity Tax Credit & Lifetime Learning Credit
The American Opportunity Tax Credit (AOTC) is primarily for taxpayers paying college tuition for dependents, yourself, or your spouse. If your MAGI is under $80,000 as an individual or $160,000 as a married couple filing jointly, you fully qualify for this credit. It then phases out over the next $10,000 (single) or $20,000 (married filing jointly) to nothing.
If you pay cash for schooling costs, you can get a 100% tax credit on the first $2,000 spent and a 25% credit on up to another $2,000. The total value of this credit is up to $2,500 per year, and it can be taken four years per student.
Working physicians are very unlikely to qualify, but most retirees will. The key is to retire or have much lower income when your children are in college. You also have to choose to pay cash for up to the first $4,000 before tapping a 529 plan.
The Lifetime Learning Credit has the same phaseout ranges, and it’s good for a credit of 20% of up to $10,000 in qualifying educational expenses like tuition, fees, and books.
Unlike the AOTC, this credit can be used for more than four years but you cannot claim both in the same year. You’re best off taking the AOTC for the first four years for a particular student and then using the Lifetime Learning Credit thereafter.
This is not an exhaustive list. Rather, it’s a list of the more common benefits and credits that a high earner can expect to see or take full advantage of for the first time when retiring early. While working, few, if any of these, will be available to the typical physician family and those with similar incomes.
Now that you have some idea of why having a low taxable income can be especially beneficial, it’s time to focus on the how.
#1: Build Up a Taxable Brokerage Account
While it’s nice to defer taxes while working by investing in a tax-deferred 401(k), 457(b), or similar account, you’ll want to invest additional money in a “taxable” account with few restrictions and numerous advantages.
If you play your cards right, a taxable account can be nearly as good as a Roth IRA and better in some ways.
In retirement, especially when retiring early, a taxable account can be a great primary source of spending. Only the gains are potentially taxable; your cost basis (what you paid for the asset) won’t be taxed when you sell.
We learned above about the 0% capital gains bracket, so even if you do realize some capital gains when selling, you may not owe any taxes on them. For example, if you sell $100,000 worth of stocks or funds that you paid $50,000 for, you realize $50,000 in capital gains. If you don’t have nearly forty thousand dollars in other income sources, your federal income tax will be $0.
#2: Make Roth Contributions While Working
There’s a clear tax benefit to having some Roth money at your disposal when retired. You won’t owe any taxes on money withdrawn from a Roth IRA or Roth 401(k).
Some of that money (the contributions you made) will be available to withdraw tax-and-penalty-free at any age (as long as you’ve had the account open for five years) and the earnings can be accessed without tax or penalty after you turn 59.5 years old.
If you are planning to retire early, Roth contributions might not make the most sense for your 401(k), but the backdoor Roth is a great option as an alternative to some of your taxable account investing, and beginning in 2023, you can contribute $6,500 to a Roth IRA or $7,500 if you’re age 50 or more. You must have that amount or more of earned income to contribute, and the backdoor doesn’t work well if you’ve got any tax deferred IRA money.
Even if you only do the backdoor Roth during you working years, you should be able to build up a six-figure Roth IRA unless you punch out within 10-15 years or so of starting your career.
The beauty of Roth money in tax planning is that there are zero tax consequences to any Roth withdrawals you make. If taking money from a tax-deferred account or selling from a taxable account would push you into a higher tax bracket or decrease a tax credit or subsidy, withdrawing from a Roth account can be an excellent option.
#3 Strategic Roth Conversions in Retirement
Converting tax-deferred dollars to Roth dollars is a taxable event. It creates taxable income. So why would this be a good strategy to employ in retirement?
Essentially, the idea is to fill some of the lower tax brackets with income rather than let those small income tax brackets go unused. It’s particularly advantageous to do so if you have a large tax-deferred balance and are concerned about having an “RMD Problem” in your later years when you’ll be forced to make required minimum distributions annually. Currently, that starts at age 72.
When should you make Roth conversions? How much should you convert? These are simple questions with complex answers that depend upon your age, your account balances, and your goals with the strategy.
If you have little Roth money, millions of tax-deferred dollars, and enough taxable income to push you out of the 0% capital gains bracket and ACA subsidy, you might want to convert right up to the top of the 24% tax bracket, which is $364,200 in 2023.
On the other hand, if you have very little taxable income and want to stay in the 0% capital gains (and qualified dividends) bracket, qualify for an ACA subsidy, and keep your taxable income within the 12% federal income tax bracket, you might convert just enough to keep taxable income at or under $89,450, the top of that 12% bracket in 2023.
For more information on the benefits and nuances of a retirement Roth conversion strategy, see Dr. David Graham’s Roth Conversions post at FI Physician.
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#4 Live in a Low-Tax State
This one isn’t as straightforward as you might think. There’s a lot more to determining a state’s retirement taxation status than simply looking at a table of tax rates for the various states.
First, your taxable income may be low enough that paying a high tax rate doesn’t equate to paying much tax.
Second, if you choose to live in an expensive home, property taxes might be a bigger factor than income taxes once you’re retired. Here’s a list of average property tax rates by state.
Third, states vary significantly in the way they tax pension income, social security income, and whether or not they recognize any kind of standard deduction. Kitces.com has a great breakdown.
Fourth, some states allow you to deduct charitable donations from your state income taxes. Others don’t. Minnesota let me deduct all of my charitable giving, whereas Michigan doesn’t even recognize it. See how every state handles charitable deductions here.
Most people will retire based on where they want to be, not what the tax repercussions are, but it’s important to understand that what’s considered to be a low-tax or high-tax state might flip flop in retirement as compared to when you were a highly-compensated worker bee.
#5 Make Qualified Charitable Distributions
When you reach the age at which you must take RMDs, you have the option of sending up to $100,000 of what would be your RMD directly to a charity.
In a couple where both partners have sufficient assets, they can each make $100,000 worth of donations to the charity or charities of their choice for a total of $200,000.
Why not just withdraw the RMD and donate an equivalent amount of money? There are a couple of advantages to the qualified charitable distribution (QCD) that are lost when taking an RMD and subsequently donating that money.
A QCD is an “above-the-line” deduction that reduces AGI (adjusted gross income) and MAGI (modified adjusted gross income), the numbers used to determine numerous phaseouts and tax credits in the tax code. An itemized charitable deduction is a “below-the-line” deduction that reduces taxable income, but not AGI or MAGI.
Also, remember what we said about state treatment of charitable giving? Some states won’t give you a penny in itemized deductions for charitable giving. When you make a QCD rather than a withdrawal, that money isn’t reported as ordinary income and you won’t pay any taxes on it. The same may not be true if you withdraw it first and then donate it, at least from a state tax perspective.
An important caveat to know is that you cannot make QCD to a donor advised fund (DAF). A DAF is a great fund to build up while working to give from during retirement, but contributions to one are not as advantageous once you’ve given up the high income.
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Estimating Your Retirement Taxation
Towards the end of the calendar year, it’s a great idea to have a good idea of what your 1040 is going to look like, and you may be able to do some year-end tax planning to fine tune things.
If you’re aiming for a taxable income just over or under a certain threshold, a precise Roth conversion, charitable donation, or realized capital gain might get you right where you want to be. Tax Gain harvesting can be a useful tool for increasing the cost basis in your taxable account, for example.
I recommend two resources for dialing in those numbers.
First is CPA Kathryn Hannah’s Personal Finance Bundle. It does a lot more than help you understand your tax scenarios, but the tax planning capabilities are what I personally find to be the most useful.
Second, for a basic look at what your taxes could be, play around with Taxcaster from TurboTax. It’s not as robust or as flexible as the bundle above, but it is great for running simple hypotheticals, and it doesn’t cost a penny.
There are some things you can do while working and more that can be done in retirement to minimize your total taxation. Use these strategies to pay your fair share, whatever that is, and not a penny more.