Thank goodness April 15th is over. This year we sent in about $300 each to the IRS and our state's department of revenue. It's not fun, but I'd rather send in a small check than get a refund.
Tax planning is even more important if you are recently retired or close to retirement. In retirement, your income will most likely be reduced, and you will need to keep as much of your income as possible. Here are a few ways to control your tax bill in retirement:
Reset your cost basis. When you have a stock investment in an after-tax brokerage account, you will have to pay tax on any capital gain from your investment when you sell it and make a profit. If the investment is held longer than a year, then it will be assessed at a special long-term capital gain tax rate. Furthermore, if you are in the 15 percent tax bracket or below, your long-term capital gain tax rate will be 0.
A retiree's income usually drops once he or she stops working. There is a good chance retirees will be in the 15 percent tax bracket and can take advantage of this rule. You can sell your stock and buy it back right away to reset your cost basis. By doing this, you'll reduce the capital gain tax when you sell later. The wash sale rule only applies when you sell at a loss so you don't have to worry about that.
There are a couple of things to be careful of. The capital gain still gets added to your adjusted gross income, so you'll have to be careful not to creep into the 25 percent tax bracket. Also, you still have to pay the state tax.
Resetting your cost basis is probably worth doing if you are in the 15 percent tax bracket. Higher earners already have to pay more tax on their long-term capital gains in 2013, and tax rates could go up in the future to pay down our huge federal deficit.
Get rid of debt before retirement. It's best to get rid of all your debt before retirement. More retirees are carrying their mortgage into retirement, and this is bad idea. Your expenses will be lower without mortgage payments, and you won't have to withdraw as much money from your tax-protected retirement accounts.
How much you withdraw from your tax-deferred retirement accounts can have a large impact on your tax liability. If your taxable income is under a certain amount, your Social Security benefit won't be taxed at all.
Pick a tax-friendly state. The state you live in can take a big bite out of your income. As mentioned above, even if you can avoid paying tax to the IRS on your long-term capital gains, your state will still take a piece of the pie. State tax ranges from 0 percent to around 10 percent. If you live in California or New York, then it might be a good idea to retire to a state with a lower tax rate.
Many retirees also plan to relocate to another country after retirement to lower the cost of living while maintaining their lifestyle. This is a good plan, but you also need to check your state tax laws to see if you need to pay tax even after moving abroad. California, New Mexico, Virginia and South Carolina all want you to pay the state tax even after you relocate.
A few states have no income tax, including Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. Moving to one of these states might lower your tax burden. However, states without an income tax generally have other taxes including property tax, sales taxes, fuel taxes and other taxes. You will need to research further to see if it's the right move for you. If you're relocating to another country, consider establishing residence in one of these states before moving. You will avoid most of the local taxes when you are not there.
Minimize tax in retirement. As always, check with a tax professional before making any big moves. We pay plenty of taxes during our working days, so why not try to minimize taxes in retirement? The less you pay the government, the more you have to spend on yourself.
Joe Udo blogs at Retire By 40 where he writes about passive income, frugal living, retirement investing, and the challenges of early retirement. He recently left his corporate job to be a stay at home dad and blogger and is having the time of his life.
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