In retirement, as in your working years, it is critical to manage your tax bracket through careful tax planning in order to maximize your income. But when you’re tapping a finite nest egg in retirement, saving every possible dollar becomes even more important.
In 2021, there are seven tax brackets, with the highest rate of 37% levied on individuals making over $523,600 annually. The American tax system is progressive, so each tax rate is levied only on the difference between the two brackets. For example, if your joining filing income is $400,000, the first $19,900 of your income will be taxed at 10%, the next chunk of your income will be taxed at 12%, and so on up to (in this case) 32%.
2021 Tax Brackets
| Tax Rate | Single Filing Income | Joint Filing Income |
| 10% | Under $9,950 | Under $19,900 |
| 12% | Under $40,525 | Under $81,050 |
| 22% | Under $86,375 | Under $172,750 |
| 24% | Under $164,925 | Under $329,850 |
| 32% | Under $209,425 | Under $418,850 |
| 35% | Under $523,600 | Under $628,300 |
| 37% | OVER $523,600 | OVER $628,300 |
As you have probably experienced, taxes can quickly eat up your income. Here are five strategies to avoid unnecessary tax bills by managing your tax bracket in retirement:
1) Maximize Your Current Tax Bracket
As people plan for retirement, they often assume they will spend the same amount of money each year in retirement, creating a smooth and consistent withdrawal stream. In reality, retirement spending can vary drastically from year to year depending on your health and lifestyle.
For example, let’s say you want to take advantage of the 12% rate. Using your projections, you expect to withdraw $38,000 in taxable income from your nest egg in order to cover your annual expenses. You’ve had good health and few expensive surprises, but you should still try to withdraw up to the full $40,525 threshold. Sure, it’s $2,525 extra you don’t need right now, but that amount will be taxed at 12% only. If you have an emergency next year and need to withdraw $50,000, every dollar over that $40,525 threshold will be taxed at a higher rate. But since you already withdrew an extra $2,525 last year, you only need to withdraw $47,475 this year – meaning only $7,475 will be taxed at 22% instead of $10,000.
2) Avoid Unnecessarily Entering a Higher Tax Bracket
The example above demonstrated how to maximize a tax bracket in order to take advantage of the most lenient tax rate possible. Now, suppose you want to do the opposite – limit your taxable withdrawals in order to keep income under a bracket threshold to leverage a lower tax rate. Filling a bracket is easy – just withdrawal more cash from a taxable account. But keeping income below a certain threshold takes more planning.
After age 72, it will be important to make sure your income strategy accounts for Required Minimum Distributions. If these annual, legally required distributions are not accounted for, you may find yourself scrambling to take them before year’s end, which will increase your income and potentially push you into a higher tax bracket.
Of course, you can’t forgo a withdrawal if you need extra cash in an emergency. However, you can utilize tax-sheltered vehicles to limit your tax burden and stay under a bracket threshold. More on that below…
3) Manage a Diverse Selection of Retirement Accounts
Retirement accounts can be tax-free, tax-deferred, or taxable. These terms describe how and when the accounts are taxed. For example, a traditional IRA or 401(k) is funded with pre-tax dollars, but you’ll pay taxes when it comes time to make withdrawals; thus, they are tax-deferred. On the other hand, a Roth IRA or 401(k) is funded with after-tax dollars. This means withdrawals are tax-free, while brokerage accounts are entirely taxable.
An efficient retirement tax strategy requires a diverse assortment of accounts. This allows the flexibility to withdraw tax-free when your income is high, or tap a tax-deferred account when your taxable income is lower.
4) Sell Stock to Leverage Capital Gains
Capital gains taxes are well below income tax levels. In fact, if you are a single filer and your taxable income is less than $40,400 in retirement, you won’t owe any capital gains taxes at all! Unlike income taxes, capital gains taxes fall into three brackets – 0%, 15%, and 20%.
Note that in order to access the capital gains rate, you must hold your asset for at least one year before selling it for profit.
5) Consider Life Insurance
Whole or universal life insurance policies aren’t like your auto or health coverage. Unlike term life, these so-called ‘permanent’ life insurance options have cash value that can be used in retirement to save on taxes.
If your income is too high to have access to a Roth IRA, using tax-free withdrawals from a permanent life insurance policy can help offset some of your taxable income. The cash value portion of the life insurance policy will grow in a tax-deferred account and the death benefit of the policy will be distributed tax-free. If you’ve maxed out your 401(k) and IRA and aren’t eligible for a Roth, using permanent life insurance to leverage better tax rates is something worth exploring.
But this path can be tricky – always make sure to consult your financial advisor before purchasing expensive life insurance.
Tax Planning with Advanced Retirement Strategies
Unfortunately, many CPAs do not assist with tax planning. They can prepare your taxes in April, but they seldom have an opportunity to consult with their clients on how they can financially plan for the coming year from a tax efficiency perspective.
That’s where Advanced Retirement Strategies comes in. Our team of experienced professionals are available to help residents of Bountiful, Utah and the surrounding areas make the most of their retirement income through careful tax planning.
Contact us today to learn more about how you can make the most of your golden years by partnering with Advanced Retirement Strategies.
