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7 Ways to Minimize Income Tax in Retirement

Joe Udo

Another tax day is over. Hopefully everyone filed their taxes on time and sent in what they owe to the Internal Revenue Service. Taxes are a fact of life when you have a full-time job, but your tax liability will probably change quite a bit after you retire. If you are still working, you are probably hoping your taxes will decrease after you retire. That's probably true, but you still need to take control of your tax situation and plan to minimize your tax liability in retirement.

When you stop working, your income will most likely decrease because you won't have income from your regular job anymore. Retirees generally have many sources of income, and they all need to be monitored carefully so you can avoid paying high taxes. Here's a look at what you can do now to minimize your taxes after you retire.

Reduce your expenses. How can reducing your expenses help with your taxes? If you don't spend a lot of money every month, you won't have to withdraw as much from your retirement fund. By keeping your expenses moderate, you will be able to stay under the 15 percent tax bracket and take advantage of many tax breaks. For married couples filing jointly, that's $73,800 after your deductions and personal exemptions in 2014.

Pay off your mortgage before retiring. One way to minimize your monthly expenses is to pay off your mortgage before retirement. Your mortgage is usually your biggest monthly bill, and if you can get rid of that, you'll have much more flexibility in retirement. It's too bad that more and more people are carrying a mortgage into retirement. It's more difficult to minimize tax if you need to withdraw a large amount to pay the monthly mortgage.

Minimize tax on your Social Security benefit. Did you know that your Social Security income is taxed based on your combined income? (Combined income is your adjusted gross income plus nontaxable interest plus half of your Social Security benefits.) If you file as married jointly and your combined income is below $32,000, you won't have to pay any tax on your Social Security benefit. But as your income increases, you will pay more and more tax on your Social Security benefit. This is another reason to keep your retirement expenses low: It will help you minimize tax on your Social Security benefit.

Dividend income and long-term capital gains. Qualified dividend income is taxed at zero percent, 15 percent or 20 percent depending on your tax bracket. If you can stay under the 15 percent tax bracket, your dividend income won't be taxed. Long-term capital gains are also taxed at the same rate as dividends.

Roth IRA and Roth 401(k). Your retirement funds in a Roth IRA or Roth 401(k) won't be taxed if your withdrawals are qualified. Generally, if you are over 59½ and the contributions were made more than five years ago, the withdrawal will be qualified. Check the IRS rule or talk with your tax advisor to make sure. Roth accounts are a great way to diversify your post-retirement income, so we all need to invest in these accounts.

Traditional IRA and 401(k) distributions. Withdrawals from your traditional IRA (deductible) and 401(k) are fully taxable. These retirement accounts helped lower your tax bill in your working years, but they will increase your tax liability once you start taking distributions.

Diversify your after-retirement income. As you can see, it's important to diversify your after-retirement income. Retirees can have income from Social Security, pensions, rentals, taxable brokerage accounts, tax-free Roth accounts, saving accounts, bonds and more. These incomes can be fully taxed, taxed at the long-term capital gains rate, partially taxed (Social Security benefit) or not taxed at all. Keeping your taxable income under the 15 percent tax bracket will help you minimize the amount of tax you pay for years to come. Give yourself more options by saving and investing in all these accounts while you are still working.

Of course, there are other ways to lower your taxable income, such as donating to charity and taking some investment losses. However, keeping your expenses low after retirement is the key to minimizing taxes. If your annual expenses are low, you won't have to withdraw a lot from the fully taxable accounts. Work with your tax accountant now to make sure you don't pay Uncle Sam more than you have to when you are retired.

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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