As you get closer to retirement, forecast your retirement spending and look at your marginal tax rate compared to your effective tax rate¹. As retirement nears, you’ll have a better idea of what your taxes will be—and you can work with a financial professional and tax advisor to make any moves that may reduce your tax burden. In the meantime, here’s an overview of tactics to consider.

Categorize assets by taxable, tax-deferred, and non-taxable investment accounts and strategically tap them.

Traditional advice from tax advisors has suggested tapping accounts in this order:

• Taxable: First, tap brokerage accounts, with the goal being to let tax-deferred and tax-free retirement accounts continue to enjoy potential grow over time^2,3.
• Tax-deferred: Next, tap tax-deferred vehicles such as IRAs. 401(k)s or tax-deferred annuities. For IRAs and 401(k)s, tax breaks occur up front, as contributions reduce taxable income and allow the money to potentially grow tax-free⁵. A tax-deferred annuity also allows your premium to potentially grow tax tree over time⁶. Plus, they have no contribution limit, in contrast to IRAs and 401(k)s⁷.
• Non-taxable: Finally, enjoy the tax-free benefit of withdrawals from any Roth IRAs or Roth 401(k)s you established^2,3,4. It’s especially helpful to use Roth withdrawals during years with a higher tax burden, perhaps a year with big capital gains or an inheritance to off-set overall tax burden. Similarly, a cash value life insurance policy can allow comfortable retirees to borrow or withdraw funds tax-free from contributions they’ve made to the policy⁸, enjoying those funds without touching any taxable earnings.

While this order represents conventional wisdom about tapping retirement accounts, financial institutions also recommend retirees consider a proportional withdrawal strategy—tapping each type of retirement account annually based on how much each represents of their overall retirement savings. Rather than waiting to tap tax-deferred accounts, for instance, they could tap both taxable and tax-deferred funds to meet annual living expenses. The advantages? The strategy may spread out the tax burden more evenly over the years and also could result in tax savings^2,3,4.

Lower taxes by reducing expenses. Pay off your mortgage and any other outstanding debt⁹, and if you’re looking to move, consider which regions might have lower retirement costs. US. News and World Report compiles a list of “Best Places to Retire in 2020-2021” based on factors that include the local residents’ happiness, housing affordability, quality of health care, and tax rates¹⁰—putting Sarasota, Florida, at the top of the list thanks, in part, to its tax benefits for retirees¹¹. Florida is a state with no income tax, as shown in this tax-rates.org map¹². The map shows income tax rates for all 50 states, including states with the highest state income tax rates, such as Maine (6.57%) and California (7.75%). For instance, your dream of retiring to Hawaii comes with state tax rates at 7.02%, and if you want to move to Minnesota, factor a 7.46% state tax rate into your retirement spending plan¹². 

Reposition assets by moving them from taxable accounts to tax-deferred vehicles, such as cash value life insurance or nonqualified annuities. Such moves may give your premium dollars time to potentially grow tax free. You can even use savings or money from brokerage accounts to purchase a tax-deferred annuity or cash value life policy. And some retirees with high net worth might even discover that a combination of a tax-deferred annuity and a cash value life policy can produce a very advantageous tax benefit to your portfolio^13,14.

Leading up to retirement, you also might consider a Roth conversion, moving funds from a traditional IRA to a Roth IRA. During the conversion year, you’ll have to pay taxes on your original tax-deductible contributions and on any tax-deferred earnings, but it helps that you’ll still be working and earning income. Later, in retirement, you’ll enjoy tax-free withdrawals¹⁵.

Guard against bumping into the next highest tax bracket, so you don’t pay higher premiums for Medicare Parts B and D and certain taxes. It’s a given that higher income Americans will pay more in taxes related to Social Security earnings because that tax threshold is relatively low¹. But there are other premiums and taxes that you can curb with a little foresight. Work with your financial planner to make financial moves that can keep you at a lower income level to pay the lesser amounts.

• Medicare Parts B and D Premiums. Those with higher income levels pay more every month for these premiums. For instance, in 2021, the highest earners will pay $504.90 monthly for Part B premiums alone¹⁶.
• Net Investment Income Tax. This 3.8% tax is levied on income from capital gains or dividends, from rental income and other investments if you meet certain income thresholds. Stay under those thresholds and you avoid that tax¹⁷.
• Alternative Minimum Tax. High-income earners must calculate their AMT tax rates along with standard tax rates and pay the higher of the two¹⁸.
• Capital Gains. The rate for higher earners is either 15% or 20%, based on income level¹⁹.

Relying on certain types of annuities to help lower your taxable rate in retirement. After maxing out 401(k)s, making IRA contributions, and perhaps investing in other brokerage accounts, annuities deserve consideration from soon-to-be retirees looking to defer tax, enjoy tax-free growth and ultimately reduce taxes. As discussed above, tax-deferred annuities only require you to pay tax on the interest earned and not on the original investment⁶. Called the exclusion ratio, this feature of annuities can allow them to play a significant role in some retirees’ overall retirement plan. You also can consider purchasing a non-qualified immediate annuity—a category of annuities bought with an after-tax sum of money. Your premium will immediately become annuitized or divided over time into monthly payments. The tax advantage is that since you purchased it with post-tax dollars, only earnings will be subject to future taxation²⁰.

Keep in mind that every situation differs, and a financial professional and tax advisor can help you make the most tax-advantaged moves as you build an income stream in retirement.