Many retirees are surprised to find that taxes remain one of their biggest expenses in retirement. While they may have paid off their mortgage and no longer have work-related costs, income taxes along with taxes on Social Security and Medicare surcharges can take a significant bite out of their retirement income.
The good news? With proactive tax planning, retirees can legally reduce their tax burden and keep more of what they’ve earned. In this article, we’ll explore smart tax strategies that can help retirees in North Carolina and beyond make the most of their hard-earned savings.
Why Tax Planning Matters in Retirement
Tax planning isn’t just for your working years. It’s especially important for those nearing and in retirement. Here’s why:
- Fewer deductions: Without mortgage interest or dependent deductions, retirees often lose some of the tax breaks they had during their working years.
- Required Minimum Distributions (RMDs): Starting at age 73, RMDs from traditional IRAs and 401(k)s can push retirees into higher tax brackets.
- Size of your Nest Egg: As your nest egg has grown over the years, so has the impact of any tax inefficiencies with your investments
- Social Security taxation: Depending on your income, up to 85% of your Social Security income may be taxable at the Federal level. North Carolina does not currently tax social security.
- Medicare IRMAA surcharges: Higher income levels can trigger additional premiums for Medicare Part B and Part D.
- Changing tax laws: Tax rates and rules change frequently retirees need a flexible strategy that adapts over time.
Without careful planning, many retirees end up paying more taxes than necessary. The key is to shift from thinking about taxes one year at a time to thinking about lifetime tax planning.
Smart Strategies for Reducing Taxes in Retirement
Manage Withdrawals Across Different Accounts
Most retirees have savings spread across multiple account types:
- Tax-deferred accounts (IRAs, 401(k)s)
- Roth accounts (Roth IRA, Roth 401(k))
- Taxable investment accounts (brokerage accounts)
The amount and order in which you withdraw from these accounts can have a big impact on your taxes. A smart strategy is to “fill up lower tax brackets” with distributions from tax-deferred accounts, while preserving Roth accounts for later years or legacy planning. Coordinating withdrawals across accounts can reduce taxes over your lifetime. By balancing your distributions and filling up the lower brackets, usually over several years, you reduce or eliminate being forced into higher tax brackets later on.
Plan for Required Minimum Distributions (RMDs)
RMDs tend to be the biggest culprit of unexpected tax spikes. Planning ahead can help smooth out taxable income. Options include:
- Roth conversions before RMDs begin
- Qualified Charitable Distributions (QCDs) to reduce taxable income
- Coordinated withdrawal strategies
- In some cases, further deferring a portion of income through the use of a specific type of income annuity referred to as a (QLAC)
Strategic Roth Conversions
Roth conversions: moving funds from a traditional IRA into a Roth IRA can be a powerful tool, especially during lower-income years (such as the window between retirement and when RMDs begin).
Benefits of Roth conversions:
- Potential to better control your tax bracket over the years
- Create tax-free income for later years, surviving spouse or heirs
- Reduce future RMDs
But timing matters a poorly planned conversion could push you into higher tax brackets or trigger Medicare surcharges. This is where careful planning with a financial advisor can pay off.
Asset Location
Just as you thoughtfully place furniture in your home, such as putting a couch in the living room or a dining table in the dining room, you should also be intentional about where you hold different types of investments across your accounts. This concept is called asset location. Certain investments, such as taxable bonds or REITs, generate income that is best sheltered inside tax-deferred accounts like IRAs. This allows you to avoid paying taxes on the income until you are ready to use the income. Others, such as index funds with low turnover, are well suited for taxable brokerage accounts. Investments with strong growth potential may belong in a Roth IRA, where future gains can be tax free. By placing each investment in the right “room,” you can make your overall portfolio more tax efficient, allowing you to keep more of your growth after taxes.
Tax Loss Harvesting
Tax loss harvesting is a strategy where you sell investments at a loss to create a tax benefit and reinvest the money elsewhere. Essentially, it’s a silver lining because unfortunately, watching your investments go down at times, is a feature, not a bug of investing. This can help offset gains that occur elsewhere. Most commonly mutual fund capital gains distributions which happen outside of your control or from selling your investments. Since market volatility doesn’t happen on schedule, this is something that should be monitored throughout the year, not just in December. If your losses exceed your gains, you may also be able to use up to $3,000 of losses each year to offset ordinary income or the unused losses can be carried forward to future tax years. This approach can take some of the bite when the market has a particularly bad year. It is important to follow IRS rules regarding the wash sales. When done thoughtfully, tax loss harvesting can help you keep more of your growth.
Coordinate with Social Security Timing
When and how you claim Social Security along with other sources of income can significantly impact your taxes. Claiming early creates income and could lower your ability to properly control your taxable income. At most, 85% of your social security benefit is taxable, so delaying benefits could force you instead to use income that is 100% taxable until you claim your social security benefits.
Watch for Medicare IRMAA Surcharges
Many retirees don’t realize that higher income can trigger Medicare premium surcharges, known as IRMAA (Income-Related Monthly Adjustment Amount).
Proper tax planning can help manage your Modified Adjusted Gross Income (MAGI) to stay below certain IRMAA thresholds, saving you potentially thousands of dollars per year in Medicare premiums.
Use Charitable Giving to Your Advantage
Charitable giving can be both personally rewarding and tax-smart. Two key strategies:
- Donor-Advised Funds (DAFs): Allow you to bunch charitable contributions into one tax year, maximizing deductions.
- Qualified Charitable Distributions (QCDs): If you’re over age 70½, you can give directly from your IRA to charity, reducing taxable income and satisfying RMD requirements.
Common Mistakes to Avoid
- Thinking only about current-year taxes instead of lifetime tax efficiency
- Failing to coordinate between financial planning and tax preparation
- Not updating your plan as tax laws and personal circumstances change
Final Thoughts: Tax Planning Is Key to Retirement Success
Taxes are one of the few factors you can actively manage in retirement. With smart, personalized planning, you can reduce your tax burden and keep more of your wealth working for you.
At Morrison Wealth Advisors, we help clients across North Carolina and a few other states, design retirement income strategies that are tax-efficient and built for the long term. If you’d like to explore how tax planning fits into your retirement plan, we invite you to schedule a complimentary consultation.
