How Can I Avoid Paying Taxes on Retirement Income?

After working hard for years, you’re going to enjoy a lot of money one day. If you manage those savings the right way, you might retire early and never worry about finance ever again.

You wouldn’t be the first one to find out that retirement isn’t as great as pictured, however. Oftentimes, there’s so much money going into taxes that one doesn’t have enough to live off of it. “Is this why I’ve been working all these years?”

You don’t want to find out too late that you didn’t earn enough for retirement. Because once you’re there, you can’t do much to fix things.

But is it really about earning or a money management problem? Because you can earn a lot and spend just as much. Or you manage your money well but still live frugally.

The answer is both. But assuming you work hard in your early years, the way you invest those dollars can make a huge difference.

Mind that there’s nothing wrong with paying fewer taxes. As long as you’re not evading the IRS, there’s no shame in that. Everybody deserves to pay less., especially in retirement. It would be dumb not to do it when all it takes is a bit of planning.

How Can I Avoid Paying Taxes on Retirement Income?

Let us say it up front: there’s no direct way to completely avoid taxes. It doesn’t matter whether it’s a disability, a low tax bracket, time in the military, investments, or pensions. You’ll always pay some taxes.

However, you can always pay less, and you should. How do you want to be treated in your later years? Today’s financial decisions will decide that.

But before you worry about it, mind that saving money is pointless when you’re already making financial mistakes. And you don’t get a second chance when it comes to retirement:

Mistake No.1: Required Minimum Distributions (RMDs at 72)

Back when compound interest was a thing, you could expect to cross the million-dollar mark if you just invest a bit every month. But times have changed.

If you consider inflation and market volatility, it will take you more than a lifetime to enjoy the “exponential returns.”

When you have so little saved up, it’s tempting to let the amount compound and trust the process. But you don’t have forever to take it out, because the IRS will penalize you for not withdrawing your money.

Also known as minimum contributions, you MUST withdraw part of your funds every year after you turn 72, with the exception of Roth IRAs. If you don’t, Uncle Sam takes 50% of your RMDs.

If you want to get rich, compound interest isn’t enough. And if your plan involves deferring taxes until retirement (traditional 401Ks), you’ll have to pay for that too.

So you should get the amount out as soon as possible.

Mistake No.2: Early Withdrawal Penalties

Or maybe not.

Unless you have a 457b plan, you have to turn 59 1/2 to access those funds. There’s nothing stopping you from withdrawing earlier except a penalty: 10% of those savings.

But that’s not all. No matter the plan, the IRS will tax the amount you retire. If you funded your retirement with taxed dollars, you have to pay taxes AGAIN.

There are two exceptions to get penalty exemption:

Mistake No.3: Ignoring Taxable Income

It’s not smart to just withdraw as much as you can from retirement accounts. Almost all retirement income is taxable (e.g., pensions). And withdrawing higher amounts puts you in a higher tax bracket.

If you ignore this fact, don’t be surprised when you retire with less money than expected. Did we mention they tax Social Security benefits as well?

Don’t worry. These rules may or may not apply depending on where you live (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming are exempt). But any year, the Government can change those terms.

Mistake No.4: Not Keeping Retirement Plan Statements

There’s a small chance that your retirement plan yields less than expected:

The IRS can audit your tax reports to correct mistakes. And the way you protect your retirement plan is by keeping the statement documents. These files show that you paid those taxes, which protects you against wrong claims.

One fifth mistake is perhaps falling for IRS scams. There’s no such thing as IRS agents asking for credit cards over the phone threatening with jail time. If you’re “losing” money on taxes anyway, make sure you don’t lose even more on fraud.

How To Lower Your Retirement Taxes

Reducing taxes can be tricky. And if there’s a great retirement vehicle, it probably has a yearly contribution cap. Whatever the case is, start investing early so the funds have enough time to compound.

You can take advantage of your tax situation in your early years, so you don’t have to pay for it in retirement.

Contribute to all retirement plans

Should you invest in traditional 401Ks, get a Roth IRA, or receive a pension? Well, why not all of them?

Anybody can open an IRA account. Whether you have a job or not, you qualify for either employer or solo 401Ks. And that doesn’t mean you can’t get a pension from your employer.

The strategy is, work for an employer who offers you retirement income for a lifetime. As for 401Ks and IRAs, they are your responsibility as an employee. Invest in them as much as you can — one doesn’t limit the other one.

Let’s say you earned a lot this year. You don’t want to increase your income bracket, so you invest most of it in retirement. But if you maxed out your accounts already, why not use other plans?

Everything you invest in retirement will exclude from your annual income, except for Roth IRAs (because you pay taxes as you contribute).

401K-Roth IRA Roll Over

You can move funds from your traditional 401K account to a Roth IRA plan, which allows you to save tax dollars. But how can that be possible, when both terms are almost the opposite?

The 401K has higher yearly limits, and the IRS doesn’t tax your contribution. High earners want to invest in a Roth IRA because you can grow your account faster, even though you pay taxes upfront. but the limit is only $6K per year (7K if 50 years old or older). When you retire, your Roth IRA funds are tax-free.

So you fund a 401K account with tax-deferred dollars to a tax-free retirement account? Does it mean you pay no taxes whatsoever? Actually, you pay for whatever amount you move from your 401K that year.

That could put you in a higher tax bracket, increasing your annual taxes. But after that, everything else is tax-free.

You won’t save much on tax, but it’s an excellent loophole if you want to invest more than $6K on Roth IRAs. When rolling over, it doesn’t consider the annual limits.

But there’s a wrong way to do it and pay taxes twice. Remember, after-tax dollars go to Roth IRAs, and pre-tax dollars go to the traditional IRA.

Borrow from your traditional 401K

According to the IRS, you only pay 401K taxes when you retire that amount. But there’s a riskier strategy for those who want to make better use of tax-free money.

You don’t pay taxes when borrowing from your traditional 401K. The imposed conditions are a limit of $50,000 or 50% of your retirement savings (unless you have less than $20K) — whichever is smaller — with a five-year term.

The idea is to invest that money so that it grows faster than in your 401K account. You can invest $50K in real estate and make around $1,000 in monthly revenue. Add that you could sell the property at an inflated price, earning more than what you borrowed.

But keep in mind that the yearly interest rate is 5.5%-7.5%. So even though you create an income stream for a lifetime, your profit margins should beat the interest.

Not only that, but the loan you return has to go through the IRS first! So you get out 50K pre-tax dollars. If you spent nothing and wanted to return the money the same day, you’d need to pay taxes. Add up a $50-$100 loan origination fee.

What if you don’t pay? No worries, there’s no debt here. But the loan is considered as a withdrawal instead, so taxes will apply. And if you’re under the retirement age, that’s a 10% penalty.

Things may not go as you expect. If you lose your job, the loan term is no longer 5 years. You have to repay in full in your next year’s tax return.

Hey, it’s not risky if you know what you’re doing. But since we’re talking of retirement, let’s stick to more conservative strategies.

Invest Long Term

Have you ever wondered how the rich avoid paying taxes? You may have heard that they don’t “trade hours for dollars.” Instead, they put their money on investments, which grow over time.

Although it’s easier said than done, you get a favorable tax situation. For annual incomes under $39,375 for singles ($78,750 for a married couple filing jointly, $52,750 as the “Head of Household”), the capital income tax is 0%. But if you go a single dollar beyond that, it’s 15%.

And if you cross $434,550, it’s 20%.

When you retire, you can expect to make a lot of “smart money,” so you don’t have to rely on active income. If that’s the case, your wealth could rely on tax-free investments.

If you don’t know where to start, US Treasury Bonds are the safest bet. But if you’d like to learn more about it, you can learn about different investment types here.

Your HSA Investment

If you have a high deductible health insurance plan, then you qualify to open a Health Savings Account.

Why does it matter?

You can invest $3500 per year here 100% tax-free. All the money invested serves to cover your medical expenses, and any amount you don’t use saves up for the next year.

It may not be the fastest investment vehicle. But we don’t know a better way to save money on healthcare, given that we’re all going to need it eventually. Take advantage while you can.

Delay your Social Security benefits

There’s no point in withdrawing more money you’re not going to use. It only increases your tax bracket for this year. So why not keep it on the account?

You qualify for SS benefits when you turn 66, and every month you delay them, you increase your reward. This accumulation stops at 70 years old but depending on when you were born, you can get up to 125 to 132% in benefits!

If you want to stay in the lower tax bracket, you totally want to delay these. Remember that, at least, 50% of your benefits are taxable. So if you want to get a 100% minimum, wait for four years more.

Donate up to $100K per year to charity

It would be a shame that you had to pay taxes even to send gifts to the people you love (there are tax rules for that!). At least, you can dedicate up to $100K annually to your favorite charity.

So if you contributed to a Roth IRA with pre-tax dollars, you can still donate and pay nothing to the IRS. But you can’t fake it.

Also, the last thing you want is to waste your retirement funds on a charity scam. Read more about it if you plan to donate some savings.

Retire to a tax-convenient state

Look. The moment you stop working, you’re free to do what you want. You neither need to keep living the way you’ve been doing so far. Since you have no job obligations, you can move to any state you like.

There are seven states in America where you don’t pay taxes for your salary, pensions, and whatnot. There are another six where corporate taxes are exempt. With so many choices, not only will you save more, but some of them might be a great place to live.

Do you imagine retiring in a quiet city with a great climate, surrounded by great landscapes, or great people? Whatever your standards are, it doesn’t have to be expensive.

Here, you can learn more about the best tax-free states.

The Bottom Line

After considering all these strategies, at least one of these tips will allow you to save on retirement tax. Some options are 100% tax-free if you’re willing to donate money or move to other states.

What matters is that you max out those retirement plans every year. With compound interest and good financial habits, you can enjoy financial comfort regardless of taxes.

Even though 401Ks are the most popular plans, you don’t know what taxes will be in the future. It can be safer to start to max out your Roth IRA first and not worry about the IRS for the rest of your life.