Tax Planning for Retirement: How to Reduce Taxes Before and During Retirement

Mark Sipos, Director, LFG Tax

Retirement changes more than the source of your income. It also changes how your income is taxed, when you must take withdrawals, and how much control you may have over your tax bill.

Effective tax planning for retirement begins before your final paycheck and continues throughout retirement. The goal is not simply to pay the least tax this year, but to create a stronger plan considering how today’s decisions may affect future tax brackets, Social Security taxation, Medicare premiums, required minimum distributions, and the assets ultimately left to your family or favorite charities.

For families with several types of investment and retirement accounts, these decisions rarely stand alone. The account you use for income this year can affect your taxes and financial flexibility for years to come.

What Is Tax Planning for Retirement?

Tax planning for retirement is the process of coordinating income, investments, account withdrawals, charitable gifts, and benefit decisions to manage taxes throughout retirement.

It may include deciding:

• Which accounts to use for retirement income
• When to recognize capital gains
• Whether to convert traditional retirement assets to a Roth account
• When to claim Social Security
• How to prepare for required minimum distributions
• Which assets to use for charitable gifts

The important word is “throughout.” A decision that lowers taxes in one year can create a larger tax bill later. In other cases, paying some tax earlier may provide greater flexibility in future years.

That is why tax planning to and through early retirement requires a multi-year view rather than a series of isolated annual decisions.

1. Understand How Different Retirement Accounts Are Taxed

Before deciding how to reduce taxes in retirement, you need to understand the tax treatment of your assets.

Taxable brokerage accounts may produce interest, dividends, and capital gains. When you sell an investment, the gain or loss generally equals the difference between the sale proceeds and your adjusted cost basis. Long-term capital gains may receive more favorable federal tax rates than ordinary income, although the rate depends on your taxable income.

Traditional IRAs, 401(k)s, and similar tax-deferred accounts usually create ordinary taxable income when you take distributions. Roth accounts work differently. Qualified Roth IRA distributions are generally tax-free, provided IRS requirements have been met. Roth IRAs also do not require distributions during the original owner’s lifetime.

A household with taxable, tax-deferred, and Roth assets may have more control over its taxable income than a household with nearly all its savings in a traditional 401(k) or IRA. This is sometimes called tax diversification.

The goal isn’t just to minimize taxes for any given year, to build enough flexibility to choose where future income comes from.

2. Reconsider the Traditional Order of Withdrawals in Retirement

A common rule of thumb is to spend taxable assets first, tax-deferred accounts second, and Roth assets last. That approach may preserve tax-advantaged growth, but it does not always produce the best lifetime result.

Spending one account at a time can create uneven taxable income. You might report little ordinary income during the first years of retirement, only to face higher income later when large IRA balances begin producing required minimum distributions.

A blended approach may work better. For example, a retiree could fund part of annual spending from a taxable account, take a measured traditional IRA distribution, and use Roth assets when taking more taxable income would cross an important threshold.

Both Fidelity and Vanguard note that withdrawal strategies should be evaluated against a retiree’s broader tax, income, Social Security, and legacy goals rather than applied as a fixed sequence.

The appropriate order of withdrawals in retirement may depend on:

1. Current and expected future tax rates
2. Spending needs and other income sources
3. The size of taxable, traditional, and Roth accounts
4. Unrealized capital gains
5. Social Security and Medicare timing
6. Charitable and estate-planning goals

The best source of income this year may not remain the best choice five years from now.

3. Use the Early-Retirement Tax Window Carefully

The years after employment income ends but before required minimum distributions begin can create an important planning window. During this period, taxable income may be lower, and retirees may have more control over how much income they recognize. This can create opportunities to take planned IRA distributions, recognize capital gains, or complete partial Roth conversions. Under current federal rules, required minimum distributions generally begin at age 73 for traditional IRAs and many retirement accounts. However, lower income does not automatically mean you should create as much income as possible. Each decision should be measured against:

• Federal and state tax brackets
• Capital-gain rates
• Social Security taxation
• Medicare premiums
• Portfolio needs
• Future RMDs

This early-retirement period can be valuable, but it is only one part of broader tax planning in retirement.

4. Evaluate Partial Roth Conversions

A Roth conversion moves money from a traditional retirement account into a Roth account. The converted amount generally becomes taxable income in the year of the conversion. Qualified withdrawals from the Roth account may later be tax-free. A conversion may deserve consideration when your current tax rate will likely be lower than the rate you may face later. It may also help if projected RMDs could be substantial or if you want more tax flexibility for a surviving spouse. A Roth conversion may be less attractive when the added income would:

• Push part of your income into a higher tax bracket
• Increase the tax rate applied to capital gains
• Cause more Social Security benefits to become taxable
• Raise future Medicare premiums
• Require selling investments at an unfavorable time to pay the tax

Rather than converting an entire account, some retirees complete partial conversions over several years. The amount converted can matter as much as the decision to convert.

Roth conversions should also be coordinated with spending needs and capital gains. Completing a conversion and selling an appreciated investment in the same year could produce a different result than spreading those transactions across separate tax years.

5. Coordinate Social Security and Medicare With Tax Decisions

Social Security benefits can become partly taxable based on the recipient’s total income and benefits. As a result, an IRA withdrawals, capital gains, or Roth conversions may affect more than the tax on that single transaction.

Medicare adds another layer. Income-related monthly adjustment amounts, known as IRMAA, can increase Medicare Part B and Part D costs for higher-income beneficiaries. The Social Security Administration generally uses modified adjusted gross income from the tax return filed two years before the Medicare premium year. That timing can surprise new retirees. A large capital gain, Roth conversion, or retirement-plan distribution at age 63 may affect Medicare premiums at age 65.

Retirement and certain other life-changing events may allow someone to request a lower IRMAA determination. Still, it is better to understand the potential effect before completing a major transaction. Good tax planning for retirement tracks taxable income, adjusted gross income, capital gains, Social Security, and Medicare as connected parts of the same strategy.

Retirement income decisions can affect your taxes, investments, Social Security, Medicare premiums, and estate plan. Learn how coordinated wealth planning can help bring these decisions together.

6. Include Charitable Giving in Your Withdrawal Strategy

For charitably inclined retirees, the asset used for a gift can matter as much as the amount given. Donating appreciated investments may allow you to support a qualified organization without first selling the investment and recognizing its capital gain. This may be more efficient than giving cash in some situations.

For eligible IRA owners, a qualified charitable distribution, or QCD, sends money directly from an IRA to an eligible charity. A properly completed QCD is generally excluded from taxable income and may count toward a required minimum distribution.

Charitable giving should be coordinated with the order of withdrawals in retirement. Giving cash while selling appreciated investments for spending may create a different tax result than donating the investments and using available cash for living expenses. The appropriate approach depends on your age, income, deductions, investment gains, and charitable priorities.

7. Review Company Stock Before Completing a Rollover

People who hold appreciated employer stock inside a qualified retirement plan may face an additional decision when they retire. Net unrealized appreciation, or NUA, is a special tax rule that may allow part of the appreciation in qualifying employer stock to receive long-term capital-gain treatment when the shares are later sold. The stock’s cost basis is generally taxed as ordinary income when it’s distributed. The NUA may remain untaxed until the shares are sold.

NUA is highly technical and sensitive to timing. Rolling employer stock into an IRA may eliminate the opportunity to use the strategy. Before moving a workplace retirement plan, investors with company stock should compare:

• A standard IRA rollover
• An NUA distribution
• Diversification needs
• Current and future tax rates
• The risks of continuing to hold a concentrated stock position

Tax treatment should not be the only consideration. Holding too much of one company can create investment risk, even when the tax strategy appears attractive.

Make Tax Planning in Retirement an Annual Process

A retirement tax strategy should evolve as your life changes.

Investment returns, spending needs, tax laws, charitable goals, healthcare costs, and family circumstances can all affect the plan. An annual review can estimate current income, project future RMDs, examine investment gains and losses, and determine whether withdrawals should come from more than one type of account. The review should also consider the surviving spouse. After one spouse dies, the survivor may eventually report much of the same income using less favorable single-filer tax brackets.

Effective tax planning in retirement connects the tax return with the investment plan, retirement-income strategy, Social Security decision, Medicare outlook, and estate plan. When each area is handled separately, an action that appears efficient on its own may create an unintended cost elsewhere.

Tax planning for retirement works best when it supports the life you want to lead. Taxes matter, but so do dependable income, investment flexibility, healthcare costs, charitable priorities, and the financial security of a surviving spouse. For many families, the challenge is not finding one tax-saving idea. It is deciding which strategies work together, in what order, and at what time.

If you would like help evaluating how tax planning may fit into your retirement strategy, Lineweaver Wealth Advisors would be happy to have a conversation. You can also find more wealth-building strategies here.

Frequently Asked Questions About Tax Planning for Retirement