Source: rocket50

By: rocket50 staff     

Date: May 22, 2023

Taxes are probably the last thing on your mind as you prepare for retirement, but with hindsight, that will likely jump to the forefront of your ‘to-do’ list.

For instance, managing state retirement income tax might save you a neat pile of money by avoiding unnecessary costs, ensuring you have more money to spend during your golden years.

You need a deeper understanding of tax laws across states, other than simply avoiding early withdrawal penalties, to maximize retirement savings. And that can be a challenge.

Some older adults mistakenly believe their taxable income will reduce in retirement, but this is not always the case. Sure, income from certain sources, like 15% of Social Security benefits, may be exempt from taxation in most states, but revenue from other sources, like retirement plan distributions, is taxable.

Knowing what types of your income are liable for taxation and what credits and deductions you may claim will save money at tax time.

So, if you want to learn how to work your way around the taxman legally, here are the top tips on navigating tax laws and maximizing your savings in retirement.

1. Utilize Health Savings Account (HSA)

Although not considered retirement accounts, Health savings accounts (HSAs) can be an efficient savings vehicle if you enroll in a high-deductible health insurance plan. 

While direct contributions to an HSA are 100% tax-deductible, contributions made through payroll deduction, like 401(k) employee payments, are tax-free.

You won’t have to worry about paying taxes on the growth of the funds as they accumulate, and HSA withdrawals are also not subject to federal income tax for eligible medical costs.

Like IRAs, HSAs are exempt from required minimum distributions (RMDs). After age 65, withdrawals made for reasons other than medical are subject to taxation as regular income for tax purposes.

The maximum deductible contribution amounts for 2023 are $3,850 for individuals, up from $3,650 in 2022, and $7,750 for a family, an increase from $7,300 in 2022.

2. Consider Tax-Free Investments

You can also consider investing some of your savings in tax-exempted bonds to keep your risk level at an appropriate level as you age. 

In most cases, treasury bonds are exempt from local and state taxes. Similarly, municipal bonds issued by states and local governments are not subject to income taxation on the federal or state level.

Note, however, that the interest rate on tax-exempt bonds is often lower than that on taxable bonds. If you want to include these options in your portfolio, research them more.

3. Live in a Tax-Friendly State

When your working years end, you must decide where to spend your retirement. Retiring or relocating to a state with lower personal income taxes is one of the best ways to maximize after-retirement savings.

For instance, the average combined local and state sales tax rate in New York is 8.52%, with a median property tax rate of $1,620 per 100k of the home value assessment. On the other hand, the average combined local and state sales tax rate in Delaware is zero, with a median property tax rate of $533 per $100k.

Every state has a unique way of taxing pension payments, 401(k) and IRA withdrawals, and other forms of retirement income, so you can leverage this to your advantage. Eight states, including Wyoming, Nevada, Washington, Alaska, Texas, Florida, Tennessee, and South Dakota, have no income taxes.

Four other states (New Hampshire, Pennsylvania, Illinois, Mississippi, Alabama, and Arizona will not tax earnings from pensions. Note that although New Hampshire does not tax your income, expect taxation on interest and dividend income.

Under federal law, states cannot impose an income tax on retirement income earned by their residents in another state. That means you can avoid paying state tax if you were making a living in a high-tax state like Connecticut or New York and then retire to low or no-tax states like Nevada or Texas.

Some states also have reduced retirement income tax rates or breaks. In some states, for instance, receiving Social Security payments or IRA and retirement plan income may be tax-free.

4. Contribute to a Traditional IRA

Distributions from a traditional IRA can be taxable, partially taxable, or tax-free, depending on how you managed the contributions before retirement.

If you took a tax deduction for contributions to the plan in a prior tax year, your distribution is likely taxable upon withdrawal up to the amount you deducted. On the other hand, if you make no tax deductions on your contributions, withdrawals will be tax-free to the extent of those non-deductions.

As per 2023 regulations, wage earners who contribute $6,500 or more to an IRA can defer paying taxes on up to $6,500 of their retirement savings. However, if you have a 401(k) through your employer and earnings are above a particular threshold, you can’t claim tax deductions for IRA contributions.

It helps to know that Illinois, Mississippi, Pennsylvania, and New Hampshire do not tax IRA or 401(k).

5. Convert or Contribute to Roth IRA

The Internal Revenue Service (IRS) allows you to move retirement savings between various retirement plans. For example, you can transfer money from a typical retirement account, such as a 401(k) or an IRA, into a Roth account.

Contribution limits to Roth IRAs are the same as traditional IRAs. In 2023, you may contribute up to $6,500 of taxable income to a Roth IRA.

Saving money in a Roth IRA sets you down a path to tax-free retirement income in the future. Contributions to a Roth IRA are tax-deductible from taxable income in the year you contributed, but withdrawals in retirement are not subject to tax. 

It helps to delay taking distributions from a Roth IRA until you are in a reduced tax band, which might be years after retirement age if you are still working.

However, if your income exceeds the IRS’s limit, your contribution amounts will likely be decreased or eliminated, and will not be eligible for a tax deduction. 

6. Plan for Required Minimum Distributions (RMDs)

RMDs apply to almost all retirement plans except Roth IRAs. It stipulates that you must begin making withdrawals or distributions from tax-advantaged retirement accounts such as 401(k)s and IRAs once you reach age 72.

The purpose of RMDs is to gradually reduce your retirement savings throughout your expected lifespan, ensuring funds aren’t permanently exempt from taxation. Failure to take an RMD on time might result in a hefty income tax penalty of up to 50% of the required distribution.

In short, you must determine how much of your retirement income will come through RMDs, as it is taxable. It is a good idea to make a strategy for withdrawing the RMDs and then following through.

An older adult can delay IRA withdrawals while still working, not 401(k) withdrawals. You can avoid this penalty using the IRS’s RMD calculator to determine how much money you must withdraw from your retirement account each year.

7. Take Advantage of the Catch-up Contributions

Since annual contributions to retirement plans like IRAs and 401(k) are limited, it is a good idea to get a head start on your retirement savings as soon as possible. 

If you are over 50 and working, you can qualify for a tax break for making catch-up contributions to your retirement account. Catch-up contributions are a great way to boost your retirement fund if you have not saved as much as needed over the years.

People aged 60–63 will be eligible for catch-up contributions starting in 2025.

In 2023, younger employees can contribute up to $22,500 to a 401(k) tax-deferral plan, while those older workers can contribute up to $30,000.

8. Contribute to a 401(k) or 403(b) plan

Contributing to a 401(k) is one of the most popular methods for minimizing taxes and maximizing retirement savings. 

If your employer provides a traditional 401(k) plan and you meet the requirements, you can make tax-deductible contributions. You won’t have to pay income tax on the funds you put into a traditional 401(k) plan until you withdraw it in retirement. 

In 2023, most employees may put away up to $22,500 in a tax-deferred retirement account such as a 401(k), 403(b), or the federal government’s Thrift Savings Plan (TSP). You will immediately obtain tax savings if you make these contributions via a deduction in your take-home pay.

Illinois, Mississippi, Pennsylvania, and New Hampshire do not tax income from TSP and 401(k). Additionally, 31 states do not tax retirement income from ex-military personnel.

9. Contribute to a Roth 401(k)

Roth 401(k)s have the same contribution limits as traditional 401(k)s but are taxed differently. When you contribute to a Roth 401(k), you are not eligible for an immediate tax break because you pay the tax upfront.

With a Roth 401(k), you can withdraw your contributions, and any investment gains earned are tax-free after you reach age 59.5. 

The IRS will make annual adjustments on contribution limits as dictated by inflation. You will incur a penalty if you withdraw cash less than five years after opening the account or before age 59.5.

10. Consider Donations and Charitable Organizations

You may not always get a tax break for charitable contributions to any charitable organization. However, you can continue to support your chosen charity while getting a tax break in a few different ways.

A qualified charitable donation (QCD) is an option if you are above 70.5 years old. QCDs are distributions made directly from an IRA to an IRS-approved qualified charity. 

Under this program, you can donate up to $100,000 straight from your traditional IRA to an eligible charity without paying any penalties or taxes, nor does it count as taxable income. Further, it may count towards RMDs when you meet certain conditions.

Another option is to establish a donor-advised fund (DAF), where you may give a large sum of money during one tax year and from which you can make gifts at any time. 

Remember, you cannot withdraw money for personal use after donating to a DAF. However, you get to exercise some advising control over which charities get contributions from your DAF.

11. Tax-Efficient Brokerage Accounts

A traditional brokerage account can also be a viable option if you have surplus amounts if you don’t mind the risks that come with investing. Although the income generated from these accounts is taxable, try these tips to improve tax efficiency:

• Hold appreciating assets for over a year to gain long-term capital gains rates (0-20%).

• Opt for tax-efficient investments like index mutual funds, ETFs, or tax-managed funds.

• Minimize trading as each trade typically draws taxes which can reduce annual after-tax returns by as much as 3%.

• The best option for those in a higher tax bracket would be tax-advantaged municipal bonds. Interests earned are usually federal tax-free, and local and state governments won’t tax you if acquired from your home state.

Remember that investments always carry some level of risk, so gauge your risk appetite before going down this path.  

Bottom Line

One of the biggest headaches upon retirement is ensuring sufficient cash flow. One of the ways you can achieve this is through navigating tax laws to maximize savings. 

As an older adult, you can enjoy a comfortable retirement by lowering your tax liability through strategies like contributing to Health Savings Account (HSA), putting money in tax-free investments, relocating to tax-friendly states, and maximizing tax-advantaged savings. 

Further, you can take advantage of catch-up contributions, invest surplus cash in tax-efficient brokerage accounts, and consider donating to IRS-qualified charitable organizations.