Imagine a retirement where you get to travel the world, pursue your hobbies, and live comfortably, all without worrying about taxes eating away at your savings. The good news is that it’s achievable. In this post we will explore three simple strategies—Social Security optimization, tax gain harvesting, and strategic income shifting—that can help you save a significant amount on taxes during retirement.
Social Security Optimization
How can optimizing your Social Security help save money on taxes? While it’s clear that Social Security provides a reliable income floor, its impact on your tax bill is often overlooked. Let’s break it down.
Assume you and your spouse both delay taking Social Security until age 70, maximizing your benefits. In 2024, if you both receive the maximum Social Security benefit, your combined annual income would be $116,952. Here’s where it gets interesting: even though your total income is $116,952, only a portion of your Social Security benefits is taxable.
The taxable amount is determined by your provisional income, which includes half of your Social Security benefits plus other income. In this scenario, with no other income sources, your adjusted gross income (AGI) would be $18,305. After taking the standard deduction of $32,300 for couples over 65, your taxable income would be zero, resulting in no federal tax liability.
In California and many other states, Social Security benefits are not taxed, so your total state tax would also be zero. Therefore, with an income of $116,952, you pay nothing in federal or state taxes. This illustrates how maximizing your Social Security benefits can significantly reduce your tax burden.
Conversely, if the same $116,952 came from a traditional IRA, the entire amount would be taxable. After applying the same standard deduction, you’d owe $9,694 in federal taxes and an additional $2,964 in California state taxes, totaling $12,658. This stark contrast underscores the importance of strategically managing your income sources.
Tax Gain Harvesting
Most people are familiar with tax loss harvesting, which involves selling investments at a loss to offset capital gains. However, in retirement, tax gain harvesting can be even more beneficial. This strategy allows you to sell investments at a gain, up to a certain threshold, without incurring taxes.
Consider a 65-year-old retiree who withdraws $30,000 annually from a traditional IRA and has not yet started Social Security. If their target income is $50,000, they need to sell $20,000 worth of assets from their brokerage account. Assuming the account has a cost basis of $250,000 and a market value of $500,000, half of the sale amount ($10,000) is a long-term capital gain.
In 2024, if their total income is $40,000 (including $30,000 from the IRA and $10,000 from capital gains), after the standard deduction of $16,550, their taxable income would be $23,450. The first $13,450 is taxed at ordinary income rates, while the $10,000 in capital gains falls under the 0% long-term capital gains bracket. This results in a minimal tax liability of $1,382, demonstrating how tax gain harvesting can significantly reduce taxes on investment income.
If this retiree decided to realize all gains in their brokerage account, their income would spike to $280,000, pushing them into higher tax brackets and incurring additional taxes like the net investment income tax and higher Medicare premiums. This example illustrates the need to balance gain realization to avoid unintended tax consequences.
Strategic Income Shifting
Strategic income shifting involves determining the most tax-efficient sources of retirement income. Let’s use Joe as an example. Joe receives $30,000 annually from Social Security and has a $1 million portfolio, split equally between a traditional IRA and a Roth IRA. He aims to live on $80,000 per year, withdrawing $50,000 from his portfolio.
If Joe withdraws the full $50,000 from his traditional IRA, his provisional income would include $25,500 of his Social Security benefits, resulting in a taxable income of $75,500 after deductions and a tax bill of approximately $8,022. However, if Joe takes the $50,000 from his Roth IRA, none of his Social Security benefits are taxable, resulting in no federal tax liability.
A balanced approach, withdrawing $25,000 from both the traditional and Roth IRAs, results in a taxable income of $34,600 and a tax bill of $1,934. This mixed strategy leverages the tax advantages of both accounts, illustrating how careful income shifting can reduce overall taxes.
Conclusion
Maximizing Social Security benefits, employing tax gain harvesting, and strategically shifting income sources are three powerful strategies to minimize taxes in retirement. By understanding the tax implications of different income sources and making informed decisions, you can significantly reduce your tax burden and enhance your financial security in retirement. Always consider consulting with a financial advisor to tailor these strategies to your unique situation and ensure optimal outcomes.