Top Ideas for Curtailing Taxes in Retirement

When you're working and earning a paycheck, your tax bill, for the most part, is what it is. Sure, you can pick up credits and deductions here and there as well as take steps to limit income distributions from your investments. But for the most part, the income taxes you'll pay are based on your salary, and there's not a whole lot you can do to meaningfully lower them.

Retirees, by contrast, may be able to exert a higher level of control over their tax bills. That's because they can control the amount and timing of some of these income streams in an effort to keep themselves in a lower tax bracket. They may also be able to fine-tune their deductions to ensure that they don't pay more in taxes than needed.

Morningstar.com readers were eager to share their tax-related retirement tips in a recent Discuss forum thread on Morningstar.com. They provided guidance on maximizing tax deductions and managing their investments to stay within the lowest income tax bracket. They also supplied tips in other areas, such as avoiding estate taxes and managing Social Security and work income to limit taxes.

You can read the complete thread or share your own tax-related tip here.

'A Huge Opportunity to Manage Both Income and Deductions'
With taxes, it can pay to look before you leap, in the view of Cgajowski, to ensure that you're minimizing taxable income. "Take some time to look ahead through this year into the next--most tax software allows for projections of income/deductions/taxes. If you are contemplating anything that will drastically alter your income or expenses, see if there's a way to minimize taxes or maximize deductions so that they help you the most," this poster advised.

For example, cgajowski went on, "Maybe you'll be selling some property and get an uptick in income--would suspending Social Security reduce the tax hit? Is it time to buy a new vehicle--and take the sales tax deduction in the same time span?"

Tomas47 noted that there's a sweet spot for this type of activity, writing, "The period between retirement and age 70 1/2 [when taxable required minimum distributions from IRAs and 401(k)s begin] provides a huge opportunity to manage both income and deductions."

Tomas47 also said that "bunching" deductions in years when he itemizes--and taking the standard deduction in other years--has been a good strategy. "I don't have a mortgage so often use the standard deduction. But every third year or so, I can accelerate some deductions to create a very large itemized deduction. 2013 is a good example. I knew I would have medical costs exceeding the 7.5% threshold. I made a large donation of highly appreciated stock to a donor-advised fund to cover several years of charitable giving. I chose to pay my fourth-quarter state estimated taxes in December instead of January and pre-paid my first-half 2014 property taxes in December instead of February."

Taylor Larimore pointed out that the pre-age-70 period can also be a good time to convert Traditional IRA and 401(k) assets to Roth. "One of the best ways I know for a retiree to avoid taxes on earnings and capital gains is to convert all or part of their Traditional IRAs and 401(k)s to Roth IRAs during the period of low income after retiring and before receipt of Social Security and required minimum distributions. The result: Contributions are tax-deductible. Accumulations are tax-free. Withdrawals are tax-free."

Yragca is on board with the conversion idea, advising, "Do it as young as you can. There's nothing like seeing your investments grow tax-free, and then not paying taxes when you withdraw."

Continuing to contribute to tax-sheltered vehicles can also be a valuable tool for those who want to work part-time in retirement.

BobVermont wrote, "If you have a part time job in retirement with W-2 wages, then you can shift money from your taxable brokerage account into your Traditional IRA (tax deductible), into your Roth IRA (not tax-deductible), or better still into both. The total cannot exceed the total W-2 wages and cannot exceed IRA contribution limits. The benefit is you can continue to 'shelter' more of your nest egg and even get a deduction for Traditional IRA contributions."

Islands is a believer in contributing to 529 college-savings plans on behalf of kids and grandkids. By contributing, one might receive a break on state income taxes, and the money compounds and may be withdrawn tax-free to pay for qualified college expenses. "We funded a 529 for our kids, but decided not to use it for our kids so it could continue tax-free for our grandkids."

'A Free Pass on Some of These Gains'
One of the big benefits of keeping one's tax bracket down is the ability to sell appreciated securities from a taxable account and owe no capital gains tax, as is the case with people in the 10% and 15% tax brackets right now.

Wrote Orygunduck, "New retirees may not realize it, by now that they no longer have a paycheck, their taxable income may well drop into the 15% tax bracket. If this occurs and the retiree(s) have capital gains on any stocks/mutual funds/exchange-traded funds, they have a free pass on some of these gains." (He went on to provide a useful example to illustrate.)

Nancyh said that's been precisely the case for her and her spouse. "Our adjusted gross income is lower in our first 10 years of retirement due to maxing out on Social Security and initiating income stream from annuities both at 70 when we'll be hit with required minimum distributions. So we've been able to live off other funds and keep in the 15% bracket, which is great for capital gains and dividends."

Uysses says that managing income to stay in the 15% income tax bracket or below is well worth the effort. "If you're in the 25% bracket due to a lot of ordinary taxable income consider substituting municipal bonds--that's one reason why munis are not just for those in the highest brackets."

Tbonds67 agreed on the merits of munis for certain individuals, writing, "Munis are still relatively cheap by historical standards, and the tax-free treatment of the coupons makes them one of the few financial gifts out there."

Orygunduck noted that investors who hold highly appreciated winners and are in the 10% or 15% tax brackets can reset their cost basis by selling their winners and then rebuying them. Thus, when they eventually sell and perhaps they're in a higher tax bracket, their tax bills will be lower.

Nancyh wrote, "I've reset the basis points on several stocks with big gains now."

But Ctyankee offered a countervailing idea: holding on to highly appreciated winners and gifting them to heirs, who will receive a step-up in cost basis upon your death. "Those with very large gains in stocks like  Apple (AAPL) in a taxable account with many years of retirement still in front of them above the 15% level [should consider] not taking a capital gain but rather take advantage of the federal exclusion on estates ($5.2 million and growing)."

In a related vein, Artsdoc shared an ingenious idea for children of parents who are in the lowest tax brackets. "My parents are in the 0% capital gains bracket, and they live in a state with extremely reasonable personal income tax with preferential long-term capital gains treatment. Long ago, I offered to pay their long-term care insurance premiums for them. Every two to three years since the beginning of the 0% capital gains bracket, I have gifted them appreciated mutual fund shares which they then sell using my cost basis. They use the money from that sale to then pay for their LTC premiums. We stay within the confines of maximal gift amounts, the sale doesn't generate any problems with their taxes, doesn't influence their Medicare premiums, and doesn't results in any taxation of their Social Security income. This has worked out well for both of us!"

Retirees should also consider the fact that two spouses can exclude up to $500,000 in gains from the appreciation of their residence, but that amount drops to $250,000 when the first spouse dies.

W004dal wrote, "I've known several retirees who wait to sell highly appreciated property until one spouse dies, and then they can only take $250,000 tax-free rather than $500,000 if they had sold earlier. For couples who are longtime holders of real estate in high-value markets (California, New York), this can be substantial."

'Make Your Social Security Annuity Worth a Lot More'
Posters also discussed the merits of factoring in the interplay between income, tax, and government-provided benefits--namely Social Security and Medicare.

Wrote Merjet: "In addition to being aware of income tax breakpoints, there is another set of breakpoints related to income (modified adjusted gross income) which determine Medicare Part B and D premiums. The extra premiums [that come along with hitting higher breakpoints] aren't gradual; the full hit comes as soon as the breakpoint is met."

Cpwcpw agreed, writing, "I try to manage my modified adjusted gross income to the Medicare breakpoints, not to the Internal Revenue Service's adjusted gross income breakpoints. You miss [Medicare's] modified adjusted gross income breakpoint by just $1, and you get clobbered."

Frries, meanwhile, advised retirees to keep their eyes on limiting taxes on Social Security benefits "Set it up to keep your Social Security tax-free," this poster advised. "Happily, Roth and health savings account distributions don't count toward modified adjusted gross income. So build large Roth and HSA balances and make your Social Security annuity worth a lot more."

Rockymountains also noted that those who retire before age 65 should pay attention to taxable income so that they can qualify for subsidies under the Affordable Care Act, as detailed in this article. 

For those who plan to continue working into retirement, MarkSinger advised, "Delay drawing your Social Security to the date that it will not be penalized for additional earnings." (This article discusses the connection between working in retirement and its effect on Social Security and taxation.)

Finally, several posters touted the virtues of tax-preparation software for seeing how all of these elements work together in arriving at your bottom-line tax bill. Revell10306 noted, "As long as you keep the prior year's tax return on your machine it retrieves all the prior information and makes the new return a simple process. The software will warn you if a contribution or deduction could or will invoke a tax penalty or some other unwanted scrutiny."

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