Whether you're planning to retire in the next few years or have already stepped back from the workforce, you may be looking for ways to extend your nest egg and provide yourself with more passive income from your investments.
In many cases, the solution lies not with the money your investments are generating, but in the tax rate that you pay on these funds. By minimizing your effective tax rate, you'll be able to retain more money in your accounts, continuing to earn dividends and fractional shares for years to come.
However, tax laws can be complicated and ever-changing, and you may need some extra help when it comes to optimizing your investments in a tax-efficient way. Read on for just a few of the ways you may be able to significantly reduce your effective tax rate after retiring from the workforce.
Calculate Your Deductions and Exemptions
Every individual taxpayer is entitled to a certain amount in standard or itemized deductions and personal exemptions from their wage and non-wage income. By knowing this amount at the beginning of the tax year, you'll be able to better plan your withdrawals from retirement and non-retirement funds.
Because each of your personal deductions and exemptions reduces your taxable income dollar-for-dollar, withdrawing pre-tax funds (like those from a 401(k) or IRA) up to the total amount of your deductions and exemptions can essentially render these withdrawn funds tax-free.
For example, if you and your spouse have a total of $40,000 in itemized deductions and personal exemptions for the upcoming tax year, the first $40,000 you earn (or withdraw from pre-tax retirement accounts) is tax-free.
Assuming you can get by with only $45,000 in spending money for that tax year, you'll be able to withdraw $40,000 from an IRA or 401(k) and the remaining $5,000 from a post-tax source (like a Roth IRA), and pay zero income taxes on these funds.
Even withdrawing the $5,000 from a taxable account will leave your effective tax rate in the low single digits with only $5,000 in taxable income.
Diversify Your Tax "Buckets"
One mistake many early retirees make is keeping all their eggs in one basket. Even if your retirement funds are spread across several different IRAs or 401(k)s, a lack of diversity in the tax treatment of these funds can leave you with fewer strategic options in retirement.
Those who are still in the workforce may want to take advantage of this earned income by opening a Roth IRA or taxable account rather than continuing to contribute only to pre-tax retirement accounts.
Even those who earn too much to contribute to a Roth directly can do so through the "back door" option, contributing to a non-deductible IRA and then converting this IRA to a Roth.
Analyze Asset Allocation
While you may periodically review your investments to ensure you're not weighted too heavily in stocks, bonds, or certain market sectors, you may not have paid much attention to the efficiency of the specific investments within each account.
Failing to do so can leave money on the table (or in the tax coffers). Because capital gains are taxed at a lower rate than other income, leaving the high-gain funds in tax-advantaged accounts can lower your overall tax rate on these funds. Meanwhile, putting hefty dividend-generating funds in a Roth can ensure you never pay taxes on these dividend receipts.
By speaking with a seasoned tax advisor early in your retirement planning process, you'll be well on your way to preserving as much of your retirement savings as possible, allowing these funds to continue to grow well into your golden years.