Taxes can be a burden at any age. However, in retirement, they can take a significant portion of your limited income, making it harder to manage your finances.
The good news is that there are steps you can take to reduce your tax burden in retirement. Here are three strategies:
1. Opt for Tax-Free Investment Income
You may have heard that investing in dividend stocks is a good way to prepare for retirement. This is because they provide ongoing income. However, the downside is that dividend income is often taxable.
A great alternative to minimize your IRS burden is municipal bonds. These bonds are issued by cities, states, and other local governments, and the interest earned is always exempt from federal taxes. Additionally, if you purchase municipal bonds issued by your home state, you may also avoid state and local taxes.
Moreover, municipal bonds tend to be more stable than dividend stocks. So, if you’re looking for a tax-efficient and low-risk investment, municipal bonds can be a smart choice.
2. Move to a State That Doesn’t Tax Social Security
For many retirees, Social Security is a crucial source of income. If Social Security is your only income, you may avoid paying federal taxes on your benefits. However, if you have other income sources, a portion of your benefits could be taxable depending on your total income.
Additionally, 12 states impose taxes on Social Security benefits to varying degrees. If you want to avoid paying state taxes on your Social Security income, you may consider moving to a state that does not tax these benefits.
Here are the 12 states that tax Social Security benefits:
- Colorado
- Connecticut
- Kansas
- Minnesota
- Missouri
- Montana
- Nebraska
- New Mexico
- Rhode Island
- Utah
- Vermont
- West Virginia
Some of these states offer exemptions for lower or moderate-income retirees, but if you want to avoid state taxes on Social Security entirely, you may want to steer clear of these states.
3. Save in a Roth IRA or Roth 401(k)
Ideally, you should enter retirement with a substantial amount saved in an IRA or 401(k). However, if you want to avoid taxes on withdrawals, consider saving in a Roth account.
Traditional IRAs and 401(k) plans provide tax deductions on contributions, but withdrawals are taxed in retirement. If you are still saving for retirement, consider funding a Roth IRA or Roth 401(k). Alternatively, you might convert a portion of your traditional retirement savings into a Roth account to enjoy tax-free withdrawals later.
Don’t Pay More Taxes Than Necessary
The more tax-savvy you are, the less money you’ll lose to the IRS in retirement. Carefully consider your investment assets, savings account types, and the state you choose to live in. All of these factors play a major role in determining your tax burden in retirement.
