Update:  Before jumping into today’s article I wanted to give you an update on the learning post from last week.  It must have struck a chord with the IR community (who, like those from Lake Wobegon are good looking and above average), because it was the most read and forwarded article on the site to date.  If you enjoy learning new things, follow along with the challenges as we go and you’ll have plenty of things to talk about at the next cocktail party.

With the current challenge I’ve memorized the Americas, Europe and Africa.  A good start, but there are a lot of countries in Asia and Oceania that will be challenging.  With that update, let’s move on to today’s post, which is an article that I wrote for the Financial Planning Association.  With tax time upon us, I thought many of you would find it helpful.


As April 17 (you have two extra days this year) rapidly approaches, people all across the fruited plain are sharpening their pencils, firing up their calculators, and figuring out what, if anything, they owe Uncle Sam.  For all the ink spilled lamenting the complexity of the tax code, doing your taxes during your working years is a pretty straightforward task for most people.  Just add up what you made, subtract any allowable credits or deductions, and then grab your checkbook.

The process is similar during retirement, with the exception that you have greater control over your income, which means greater control over your tax bill.  That control means you can stretch your nest egg further by making good distribution decisions.  With that in mind, here are five ways to minimize your tax bite during retirement.

Know which accounts to access first

The money you’ve saved for retirement is likely held in different types of accounts that are taxed differently.  Some accounts are fully taxable, while others, like traditional IRAs, defer taxes until you withdraw the money.  Still other accounts, like Roth IRAs, may be free from federal taxes altogether.

Which accounts should you tap first?  A good rule of thumb is to take money from your taxable accounts first.  This will allow the money in your tax deferred accounts to continue compounding.  Access tax-free accounts last.

One exception to the rule of thumb might be if you are in a lower tax bracket now and anticipate that you will be in a much higher tax bracket in the future.  In that case, you may want to begin taking distributions from your tax-deferred accounts earlier.  In any event, work closely with your tax and financial advisers each year to make distributions decisions that make the most sense for your specific situation.

Minimize taxes on Social Security

If Social Security is your only source of income, chances are that you will not need to pay taxes on those benefits.  If you have other income sources, however, you may need to pay taxes on a portion of your benefits if your modified adjusted gross income (MAGI) plus one-half of your Social Security benefits exceeds what the IRS calls the base amount for your filing status.

For example, if your MAGI plus one half of your Social Security benefits is between $32,000 and $44,000 (for those married filing jointly) in 2012, you may need to pay taxes on 50 percent of your Social Security benefits.  If your income exceeds $44,000, you will likely need to pay taxes on 85 percent of your Social Security benefits.  Armed with this knowledge, it’s easy to see how a poorly timed IRA distribution or acceptance of some part-time work during retirement can impact your tax bill in a given year.

Relocate to a tax-friendly state

Different states tax things differently.  Consequently, where you decide to live during retirement is no small decision when you think about the various types of taxes that you pay (e.g. income taxes, Social Security and Medicare taxes, capital gains taxes, dividend taxes, property taxes, sales taxes, estate taxes and inheritance taxes).  If a particular state is willing to cut you a break in one or more of these areas, it is worth factoring that into your decision making.

For example, do you plan on working at least part time during retirement?  There are seven states that do not impose personal income taxes.  Will most of your income be from Social Security?  Thirty-six states don’t tax Social Security benefits.  Do you anticipate a free-spending retirement?  There are five states with no sales taxes.  Do you have a pension?  Ten states don’t tax federal, state and local pension income.  Before deciding where to live, inventory your income streams and decide which state will allow you to keep more of what you make.

Consider tax-free bonds

Municipal bonds are issued by states or municipalities and are usually exempt from federal taxes.  They may also be exempt from state and local taxes if you live in the state that is issuing the bond.  This preferred tax treatment along with their historically low default rate make municipal bonds a staple in many peoples’ retirement accounts.

Take advantage of Net Unrealized Appreciation (NUA)

If you own highly appreciated company stock in your 401(k) or other employer sponsored plan, you should review your options carefully before rolling that money into an IRA when you retire.  That’s because tax law permits you to distribute those shares from your 401(k) and pay income tax on the basis (your original purchase price) of the shares while continuing to defer the taxes on the unrealized gains.  Once the stock is eventually sold, you will only pay capital gains taxes on the difference between your basis and the sale price.  If, however, you roll all of those shares into your IRA at retirement, you will pay ordinary income taxes on the entire amount when you eventually distribute it from your IRA.

This strategy might be particularly appealing to someone in a high marginal tax bracket who currently pays income taxes at a much higher rate (35 percent) than capital gains taxes (15 percent).

Unfortunately, your tax bill doesn’t retire when you do, but there are actions you can take to minimize what you owe.  By working closely with your advisers, you can maximize your income and increase retirement security.

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