Secrets to Reduce Taxes in Retirement

What are some ways for federal employees to reduce their taxes in retirement?

Unexpected tax bills or increased tax rates are no fun–especially in retirement. How can you reduce the taxes you’ll have to pay when you’re no longer working? Are there any proven secrets? That’s our focus in this video/blog post.

Don’t get surprised!

As some people accumulate retirement assets, they unknowingly accumulate a lot of tax obligations too–taxes that will eventually have to be paid. Many are shocked when that payday arrives in retirement. 

Fortunately, with some careful planning, you can regain some control. You can take steps now that will affect when and how you pay taxes, and how much you pay. Our goal, of course, is to reduce your tax burden in retirement as much as possible. 

Before we look at some ways to reduce those taxes, let’s look at what retirement income is taxable.

What retirement income is taxable?

  • You’ll pay taxes on your federal pension. (This is true for most federal retirees.) 
  • Because your combined income will likely be over the limit for Social Security, you’ll have to pay taxes on 85% of your Social Security income. 
  • You’ll pay taxes on any distributions from a traditional Thrift Savings Plan (TSP) or traditional IRA. 
  • If you’re getting a special retirement supplement, that will be taxed. 
  • Required minimum distributions (RMDs) are taxable. (Remember, when you reach the age of 73 or age 75, you must take distributions from your traditional accounts, and those withdrawals will be fully taxable at whatever your tax bracket happens to be.) 

Too much income?

Many retirees are surprised to find that their income actually goes up once they quit working! Maybe you retire and initially just have your pension and the supplement (that ends at age 62). But then, when you “turn on” Social Security, that boosts your income. Next, if you start taking traditional distributions too, that elevates your income even more. Finally, if required minimum distributions (RMDs) kick in and you’re forced to withdraw more money, now your income is higher than you expected.

If you don’t do any planning, it’s easy to lose control over your income and thereby lose control of your taxation. 

If every source of your income is taxable, you don’t really have much choice. Social Security allows you to delay taking payments until age 70, but then you have to turn it on. RMDs also have a deadline when you finally have to start taking them. So, even if you happen to have enough cash flow to live in retirement where you don’t need these income streams, at some point, you will have to turn them on. And that will mean increased taxable income.

A different tax bracket?

Other life events that can affect your tax status in retirement are the death of a spouse or a divorce. These situations will bump you from the “married filing jointly” tax bracket into the “single” bracket.  

Many times, this acts as a tax increase because you move up that “single” tax bracket so much faster than you do in the “married filing jointly” tax bracket.

Of course, when you pass away, you will leave all your assets to someone. If that’s traditional money, your beneficiaries will have to pay taxes on those inherited funds. It seems like taxes are a never-ending, lifelong battle!

So, let’s talk about what you can do to try to limit and even reduce those future taxes. 

A Roth conversion strategy

The first step is to look at your tax return and figure out a Roth conversion strategy. Can you come up with a plan for moving your traditional money over to a Roth account year after year–so that by the time of retirement, you’ve already paid the taxes you owe on those funds? 

Ask yourself: “What tax bracket am I comfortable with?” Finding that bracket and then maximizing it each year by doing Roth Conversions can be a way to take advantage of today’s tax rate–especially if you think that next year or 10 years from now tax rates will be higher. 

If taxes do rise over the next few years, then doing Roth conversions now–at lower tax rates–would be beneficial to you.

This is a year-by-year strategy. You let the Roth conversions do the heavy lifting of shifting your taxable income from “later” to “now.” And you do this as much as you can without going up into a tax bracket that you don’t like. This is one way to take back control of when you pay your taxes and what tax rates you pay.

Roth conversions can get tricky!

As we often point out, you can’t do Roth conversions inside a Thrift Savings Plan (TSP) account. You first have to move your money into a traditional IRA. Then, and only then, can you start doing Roth conversions. 

Now, can you set all this up on your own? Sure! You can open up a traditional IRA, move money from your TSP into that account, pay taxes on those conversions, then move the money into your Roth IRA. 

But there are some confusing aspects to doing Roth conversions, and you can run into pitfalls if you don’t think through everything carefully:

  • How much money do you want to convert? 
  • How often will you do it? 
  • What time of the calendar year will you do it? 

Such questions are where professionals can provide tremendous help and value to you.

If you’d like assistance with setting up and executing a Roth conversion strategy, I’d be glad to help.

Taxes and charitable giving

Another secret to reducing taxes in retirement has to do with charitable giving. 

When you reach the age of 70 and a half, you can do what’s called a qualified charitable distribution (QCD). This is where you give money to a church or charity directly from your IRA, and neither you nor the charity has to pay taxes on it. 

If you’re someone that gives to your church or donates to charity on a regular basis already, this can be a great tax-saving tool.

A side note: When the IRS increased the standard deduction several years ago, lots of people weren’t able to write off charitable giving anymore. That’s because the standard deduction is higher than all their itemized deductions (which is how and where the IRS designates charitable giving).

An example

So, let’s look at a hypothetical. Let’s say you currently give $500 a month from your checking account to your church. That’s $6,000 a year in gifts. But, because of your tax bracket, for you to be able to give away $6,000, you actually have to earn $8,000 and pay taxes first on those earnings in order to have $6,000 left over to donate.

With a QCD, you can give to your church straight from your IRA! Where ordinarily you would have to earn $8,000, and then pay taxes first to be able to give $6,000, you would not have to do this in this case. By sending the gift directly from your IRA to the church, you could give the full $8,000. See the advantage? They get more money and you get to take advantage of the tax efficiency of the QCD.

This feature either allows you to be extra charitable at no extra cost or allows you to maintain the current amount of charitable giving and save money for your other expenses. 

Once again, this is something that you cannot do inside of your Thrift Savings Plan (TSP). To do a qualified charitable distribution (QCD) you have to be 70 and a half years old, and you have to have the money in an IRA.

Now, does this feature save you so much in taxes that it’s going to convince a non-charitable person to suddenly be charitable? Probably not. But if you’re already charitably-minded, and you’re already giving money consistently to churches or charities, you can have the money come directly from your IRA, starting at age 70 and a half.

This is one more way that working with a professional who understands tax rules can help you accomplish your financial goals. A good planner can help you be more charitable, if that’s your goal, or potentially save on taxes. Either one of those options is good in my book.

Hey, if taxes and TSPs and IRAs and QCDs are stressing you out, you don’t have to struggle alone. We can help you take the mystery out of retirement.

About the Author

Mel Stubbs is a Financial Planner and educator at Christy Capital who works with federal employees all over the country, teaching them how their retirement system works and how to plan for retirement using their available benefits.