There are many expenses that tend to be stressful for retirees. Healthcare is a big one, as it can eat away at a lot of income. The same holds true for housing. But one expense that really tends to catch seniors off-guard is none other than taxes.
It's a huge misconception that when it comes to paying taxes, retirees are largely off the hook. Not so. Seniors are required to pay taxes on traditional retirement plan withdrawals, pension income (most of the time), and earnings from part-time work, among other things.
If you're worried about paying taxes in retirement, there are several things you can do to lower that burden and shield more of your income from the IRS. Here are three to start with.
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1. Save in a Roth IRA or 401(k)
Traditional IRAs and 401(k)s offer an immediate tax break for making contributions, since they're funded with pre-tax dollars. Roth IRAs and 401(k)s, on the other hand, do not.
But whereas traditional IRA and 401(k) withdrawals are taxed in retirement, Roth plan withdrawals are taken tax-free, which means that by forgoing a tax break up front, you're buying yourself the option to pay less tax in the future. This is an especially wise move if you think you'll be in a higher tax bracket in retirement than you are today (say, because you're amassing a large amount of savings).
2. Load up on municipal bonds
Bonds are generally considered to be a good investment for seniors, since they're subject to less volatility than stocks. But bonds come in a number of forms, and from a tax-related standpoint, it pays to favor municipal bonds.
Municipal bonds are those issued by cities, states, and counties. They work similarly to corporate bonds: You invest a certain amount of money up front, agree to lend it to the issuer over a preset period of time, and collect semiannual interest payments until your bonds come due and your principal is repaid. Those twice-a-year interest payments can serve as a solid income stream in retirement, but as is the case with most forms of income, the IRS is entitled to a share of that money if it's collected from corporate bond issuers. The benefit of buying municipal bonds is that their interest is always exempt from federal taxes, and if you buy bonds issued by your home state, you won't have to pay any state or local tax, either.
3. Move to a state that doesn't tax Social Security
Low-income seniors can often avoid federal taxes on their Social Security benefits, whereas middle- to high-income seniors' benefits are often subject to federal taxes to some degree. But it's not just the federal government that can tax those benefits. Some states also impose a tax on them, so moving someplace where that won't happen can help you avoid losing money.
There are 13 states that tax Social Security benefits at present:
- New Mexico
- North Dakota
- Rhode Island
- West Virginia
Most of these states offer an exemption that let low- or even middle-income households off the hook for taxes. But Minnesota, North Dakota, Vermont, and West Virginia offer no exemption whatsoever.
Of course, you shouldn't just pack up and move to a state that doesn't tax Social Security before seeing what the cost of living is like there. In some cases, it's worth losing a portion of your benefits to taxes if it means enjoying cheaper rent, goods, and services locally. But from a strictly tax perspective, living outside the above 13 states is a good way to lower your retirement tax burden.
Taxes are a drag at any stage of life, retirement included. If you want to avoid paying them as a senior, stash your savings in a Roth account, favor municipal bonds over corporate ones, and choose your home state carefully. With any luck, that'll do the trick in keeping the taxman away from your money.
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