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The Importance of Tax Efficiency in Retirement

tax efficiency in retirement

You may not realize it, but Uncle Sam becomes your partner in your retirement.

Back in 2010, Lincoln Financial Group sponsored a survey of affluent retirees that shows how big of an effect taxes may have. The survey gathered data from people ages 62 through 75 with annual household incomes greater than $100,000.

Of all retirement spending areas, the study found that federal income taxes were the retirees' largest expense. "They are greater than many individuals planned for prior to retirement—and a growing source of concern," the survey reported.

If you don’t want everyone’s least favorite uncle to be the "majority owner" of your retirement income, it’s important to take steps to maximize the tax efficiency of your retirement income plan.

Uncle Sam Says "Pay Me Now or Pay Me Later"

Many sources have probably encouraged you to contribute to an IRA or a 401(k) plan, to build up a retirement fund with pre-tax contributions. Your untaxed contributions grow tax-deferred over time because the growth in qualified retirement plan accounts is not subject to income taxes.

When you retire, you begin to make withdrawals from the account. These withdrawals are subject to your ordinary income tax rate. Ideally you will find yourself in a lower income tax bracket then to lessen the impact of giving Uncle Sam his cut.

But this isn’t always the case.

How Could Taxes Be Higher in Retirement?

It seems logical that when you retire you are no longer receiving income from a salary or perhaps other income means that you had in your working years. So how could your taxable income actually stay the same or increase?

It depends on your individual circumstance, of course, but here are a few factors that could contribute to you being placed in a higher tax bracket:

  • You may lose valuable tax deductions and credits as you age
  • You may wind up working longer than you anticipated
  • You may have more taxable income than you planned for
  • If you reach age 70.5 and are required to start taking Required Minimum Distributions

According to the American Association of Individual Investors (AAII), the December 2017 passage of the Tax Cuts and Jobs Act has an important potential impact on us all. In its March 2018 AAII Journal the organization provides this warning: "A change to how inflation adjustments are calculated could increase the amount of adjusted gross income reported and bump some individuals into a higher tax bracket."

The AAII article added, "Put another way, depending on your income and deductions, you could end up paying more in federal taxes than you would have otherwise if Congress had not changed the inflation measure."

New Individual Brackets with Tax Reform Law

In that same article, AAII notes that tax reform changed income brackets for federal tax purposes. Having gone into effect in 2018, the new tax brackets for individual taxpayers are:

  • 10%
  • 12%
  • 22%
  • 24%
  • 32%
  • 35%
  • 37%

Taxpayers should also be mindful of other changes, says AAII: “It’s not just the brackets that have changed, but the breakpoints at which each higher tax rate goes into effect have also changed. The income ranges at which the third, fourth and fifth brackets are hit are now higher than what they would have been without the [tax reform bill].”

“Since the tax system is progressive, this change helps to reduce the effective federal tax rate paid by higher income earners, all else being equal. The revised tax brackets and rates are set to expire on December 31, 2025.”

You can read more about other changes affecting taxpayers here.

With Plenty Comes Plenty of Taxes

It's not only that. The higher your income, the more likely your Social Security benefits will be taxed. In turn, it can reduce that monthly income you were likely counting on.

Once you are in retirement there are a plethora of taxes that may pile up on one another, including:

  • Federal income tax,
  • State income tax,
  • Capital gains taxes,
  • Property taxes,
  • Real estate taxes (for real estate assets outside of your personal domicile), and
  • Much more.


That’s why it’s important to heed your potential tax burden in retirement and create a retirement strategy that considers the tax implications of every move. We can think of retirement like a chessboard. Ideally, a strategy should be planned well in advance of making a move with that first pawn.

Potential Strategies That May Improve Your Tax Position

If you want to minimize your taxes, TheBalance.com suggests being mindful of personal tax brackets and how that may affect capital gains tax obligations. Specifically, the author mentions that aiming to stay in the 15% tax bracket may result in minimal to no capital gains taxes. With tax reform being passed, the breakthrough points for those have changed.

AAII mentions: "Capital gains and qualified dividends will continue to be taxed at the 0%, 15% and 20% rates, but the breakpoints have been adjusted. The maximum income for the 0% rate is $77,200 for married joint filers, $38,600 for single and married separate filers and $51,700 for heads of household."

According to TheBalance.com, "The key is to accurately forecast your taxes and get as close to the maximum as possible without going over. If you find that you will only have taxable income of $60,000, take distributions from your retirement accounts of $15,900 even if you don’t need it and save it for future years."

Other Potential Tax Strategy Options

Diversifying your income in retirement is another strategy to consider. Having a mix of taxable and non-taxable accounts and vehicles gives you flexibility. You can draw from non-taxable sources when your income is comparatively higher and draw from taxable accounts when it is lower.

Owning an annuity may also help you be more tax-efficient in retirement. If you purchased an annuity with non-qualified funds (money that has already been taxed, generally like in a brokerage account or a savings account), the payments you receive may be partially tax-free, according to Kiplinger.com.

"The portion of each payment that represents a return of your [money] is tax-free; the portion that represents [interest] earnings is taxable." You would receive a 1099-R from the insurance company you purchased the annuity from that would indicate your taxable amount.

An Ounce of Prevention

As many retirees are experiencing, when taxes aren’t a prime focus of retirement planning, they can become a significant financial burden when you need it the least. You don't have to let Uncle Sam take a penny more in retirement than you need to.

Work with a financial professional to consider all the ways you can deploy your money. Guidance from a financial professional -- and a tax professional as well -- can help ensure you have all the pieces in place for a rewarding, not taxing, retirement.

If you are ready for help to make the most of your efforts, financial professionals stand ready to help you here. Use our "Find a Financial Professional" section to connect with someone directly. Should you need a personal referral, call us at 877.476.9723.

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