Actionable Strategies and Money-Saving Tips for Tax Efficiency
Now that you understand the basic rules, you can start building a strategy. The goal is to get the money you need while paying the lowest possible amount of tax over your lifetime.
1. Strategize Your Withdrawal Order
The order in which you tap your accounts can have a huge impact on your long-term financial health. While every situation is unique, a common and effective strategy is to withdraw funds in this order:
First, from your taxable brokerage accounts. Why? The tax impact is often the most manageable. You’re only taxed on the gains, and if they are long-term, the tax rate is favorable. For some retirees, the long-term capital gains rate may even be 0%.
Second, from your tax-deferred accounts (Traditional IRA/401(k)). You have to take RMDs from these accounts eventually, so you will be forced to draw from them. By taking withdrawals strategically, you can control how much taxable income you declare each year.
Last, from your tax-free accounts (Roth IRA). Think of your Roth account as your golden goose. Since withdrawals are tax-free, this money is best left to grow for as long as possible. It can be a powerful resource for large, unexpected expenses or for later in retirement when your other accounts may be dwindling and your RMDs are larger.
2. Manage Your Tax Bracket
Your income in retirement is not fixed; you have control over it based on how much you withdraw from your tax-deferred accounts. You can use this to your advantage by “filling up” your lower tax brackets each year. Federal income tax brackets are progressive, meaning you pay a higher rate only on the money that falls into each successive bracket.
For 2024, the 12% federal tax bracket for a married couple filing jointly extends up to $94,300 of taxable income. The next bracket is 22%.
Example: Suppose your fixed income from Social Security and a small pension gives you a taxable income of $60,000. You have $34,300 of “room” left in the 12% bracket ($94,300 – $60,000). If you need extra cash, you could withdraw up to $34,300 from your Traditional IRA and pay only 12% federal tax on it. If you took out $40,000, that last $5,700 would be taxed at the higher 22% rate. By managing your withdrawals, you can avoid this jump.
3. Consider Roth Conversions Before RMDs Hit
A Roth conversion is a powerful tool for long-term retirement planning. It involves moving money from a tax-deferred account (like a Traditional IRA) to a tax-free Roth IRA. When you do this, you must pay ordinary income tax on the entire amount you convert in the year of the conversion.
This may sound painful, but it can be a brilliant move. Why?
- You pay taxes on your own terms. You can convert funds during years when your income is lower (for instance, after you retire but before you start taking Social Security and RMDs). This allows you to pay tax at a potentially lower rate than you would in the future.
- You reduce future RMDs. Money in a Roth IRA is not subject to RMDs for the original owner. By converting funds, you lower the balance in your Traditional IRA, which in turn lowers your future RMDs and the associated tax bill.
- You create a bucket of tax-free money. This gives you ultimate flexibility in retirement.
4. Use a Qualified Charitable Distribution (QCD)
If you are charitably inclined and are age 70½ or older, the QCD is one of the best tax-saving tools available. A QCD allows you to transfer up to $105,000 (in 2024) per year directly from your IRA to a qualified charity.
The benefits are twofold:
- The distribution is not included in your taxable income for the year.
- The QCD can count toward satisfying your RMD for that year.
This is a much better strategy than withdrawing the money first, paying taxes on it, and then donating the after-tax amount. The QCD allows you to meet your charitable goals while directly reducing your tax liability.
5. Plan for Social Security Taxation
A surprise for many retirees is that their Social Security benefits can be taxable. Whether they are depends on your “provisional income.”
Provisional Income = Your Adjusted Gross Income (AGI) + Nontaxable Interest + 50% of Your Social Security Benefits
For 2024, if you’re filing jointly:
- If your provisional income is between $32,000 and $44,000, up to 50% of your benefits may be taxable.
- If your provisional income is over $44,000, up to 85% of your benefits may be taxable.
Every dollar you withdraw from your Traditional IRA or 401(k) increases your AGI, which in turn increases your provisional income. By carefully managing these withdrawals, you may be able to keep your provisional income below a key threshold, thereby reducing or eliminating the tax on your Social Security benefits.
