Can I lower my income tax bill now that I’m retired?

Key Points

  • It's important to understand how the IRS categorizes (and taxes) different types of income. There are three major categories of income: ordinary income, capital income, and passive income.
  • To minimize taxes—and maximize what you actually get to keep—put your most tax-efficient investments (those that lose less of their return to taxes) in your taxable accounts and your least tax-efficient investments (those that lose more of their return to taxes) in your tax-deferred accounts.
  • Be tax-wise as you withdraw your income. To the extent that you rely on income from your portfolio, it's important to consider taxes as you sell investments and withdraw funds.

Editors' Note: This article is excerpted from The Charles Schwab Guide to Finances After Fifty, available in bookstores nationwide. Read more at http://schwab.com/book.

By the time you've been paying taxes for decades, you get it. The tax code is absurdly complicated and enough to make any of us (myself included) want to run for cover. On the other hand, like me, you probably want to be a good citizen and pay your fair share but not a penny more.

Unfortunately, these two realities don't fit together. Just completing your tax return every year can be a monumental task. And figuring out how to manage your tax bill takes even more work. It takes long-term planning, short-term decisions, and a solid understanding of tax concepts. I'll go over some basics here, but I also highly recommend that you enlist the ongoing help of a great CPA, particularly as you first move into retirement.

When it comes to taxes, there are both advantages and disadvantages to being a retiree. On the plus side, you may have more control over your income, and therefore more strategies for controlling your taxes. On the minus side, you may well have more at stake, and certainly more to think about. 

Understand How Different Types of Income Are Taxed

Before I get into strategies, it's important to understand how the IRS categorizes (and taxes) different types of income. In the eyes of the IRS, there are three major categories of income, which are taxed as follows:

  • Ordinary income: From wages, self-employment, interest, dividends, etc.
    • Taxation: In 2013, ordinary income is taxed at a marginal rate ranging from 10 percent to 39.6 percent, with the highest earners paying the most. Note, though, that some interest income is tax-exempt (for example, interest from state and local municipal bonds), and some dividends are considered qualified and therefore receive special long-term capital gains tax treatment.
  • Capital income: From the sale of property. Capital gains and losses can either be short-term (held for one year or less) or long-term (held for more than one year). There are also special categories for things such as collectibles.
    • Taxation: Short-term capital gains are taxed as ordinary income. In 2014, long-term capital gains and qualified dividends are not taxable for taxpayers in the 15 percent ordinary bracket or lower. For those in the 25 percent bracket or higher, long-term capital gains and dividends are taxed at 15 percent. For single filers with taxable income over $406,750 (or $457,600 for married filing jointly), long-term capital gain and qualified dividend income over that amount is taxed at 20 percent. Long-term capital gains on collectibles are taxed at 28 percent.
  • Passive income: From investments in real estate, limited partnerships, or business activities where participation is "immaterial."
    • Taxation: Ordinary income tax rate. Passive losses can usually only off set other passive income, not ordinary income.

Marginal vs. Effective (Or Average) Tax Rate

Because taxes are progressive, meaning that we pay a proportionately larger amount of taxes on higher levels of income, there are two tax rates that you need to be aware of: your marginal rate and your effective rate.

Your marginal tax rate is the amount of tax you pay on your last dollar of income. For example, in 2014 if you're married filing jointly and in the 25% tax bracket, you will pay $25 in taxes for every $100 of taxable income above $73,800 and up to $148,850. This is important, so that you will know, for example, how a bonus or other extra income is taxed.

Your effective tax rate is the average tax rate you pay when you take all of your income into account. This is important, for example, if you're figuring out the tax impact of an investment. Your effective rate (also known as the average rate) is most likely lower than your marginal rate.

AT A GLANCE: HOW YOUR RETIREMENT INCOME IS TAXED

Social Security benefits

Up to 85% of benefits taxed at your ordinary income rate. In 2013: Singles— income less than $25,000, benefits not taxed; income $25,000– $34,000, 50% of benefits taxed; income over $34,000, 85% taxed

Married filing jointly— income less than $32,000, benefits not taxed; income $32,000– $44,000, 50% of benefits taxed; over $44,000, 85% taxed

Pension income

Fully or partially taxed as ordinary income, depending on whether contributions were tax- deferred

Annuity income

Fully or partially taxed as ordinary income, depending on whether contributions were tax- deferred

Traditional 401(k) Distributions

Fully taxable as ordinary income

Traditional deductible IRA distributions

Fully taxable as ordinary income

Traditional nondeductible IRA distributions

Distributions of contributions tax- free, earnings taxable as ordinary income

Roth IRA and Roth 401(k) distributions

Tax- free provided you are 59½ and the funds have been in the account for at least five years
 

Taxable account withdrawals

Taxed as short- or long- term capital gains. Interest from municipal bonds is exempt from federal income tax, but gets added back for computing taxability of Social Security benefits (however, interest from "private activity" bonds could be included when computing the alternative minimum tax). Income from Treasury bills and bonds is exempt from state (but not federal) income tax.

Note: As a result of the Affordable Care Act, there is a 3.8 % surcharge on net investment income for taxpayers with an adjusted gross income over $200,000 (for single filers) or $250,000 (for married filing jointly).

Be Smart About Where You Place Your Investments

I've said it repeatedly: As an investor, your first priority is your asset allocation. Next comes diversification and your individual security selection. But paying attention to your taxes is important, too. To minimize taxes, and therefore maximize what you actually get to keep, put your most tax-efficient investments (those that lose less of their return to taxes) in your taxable accounts and your least tax-efficient investments (those that lose more of their return to taxes) in your tax-deferred accounts— as shown in the following chart.

AT A GLANCE: TAX- SMART PLACEMENT FOR YOUR INVESTMENTS

Taxable accounts are
the best place for:

Tax- deferred accounts
such as traditional IRAs
and 401(k)s are the best
place for:
 

Roth IRAs or Roth
401(k)s are the best
place for:
 

• Individual stocks you
plan to hold more than
one year
• Tax- managed stock
funds, index funds,
exchange- traded funds
(ETFs), low- turnover
stock funds
• Stocks or mutual funds
that pay qualified dividends
• Municipal bonds/I Bonds

• Individual stocks you
plan to hold one year or
less
• Actively managed funds
that may generate
significant short- term
capital gains
• Taxable bond funds,
zero- coupon bonds,
inflation- protected
bonds, or high- yield
bond funds
• Real estate investment
trusts (REITs)
 

• Assets that you believe
have the greatest chance
for the largest return

SMART MOVE: If you believe that you will be in a higher tax bracket at a later date (for example, if you're currently delaying Social Security or if you're expecting an inheritance), you can consider converting all or part of your IRA to a Roth IRA. Not only will your eventual withdrawals be tax- free; there also will be no RMDs. Plus, converting your account to a Roth can be a boon to your heirs.

Be Tax-Wise as You Withdraw Your Income

To the extent that you rely on income from your portfolio, it's important to consider taxes as you sell investments and withdraw funds. In a nutshell, it's generally best to:

  1. Sell from your taxable accounts before tapping your tax-deferred accounts
  2. Sell securities from overweighted asset classes
  3. Sell lower-rated securities before higher-rated securities. If you need to sell high- rated securities from your taxable accounts, sell those that will generate a loss before those that will generate a gain.

When it comes to taxes, it's essential to think long-term. But you can have an impact by thinking year-to-year as well. For example, if you've made a large charitable contribution or have paid extraordinary medical bills, you might be able to take a larger distribution without increasing your taxes. Conversely, you might want to reduce your distributions in a year with unusual income.

Harvest Your Losses from Your Taxable Accounts

No one wants their investments to lose money. But tax-loss harvesting can turn a loss into a plus, if not an out-and-out win. Here's how the process works:

When you sell your investments in a taxable account, you can erase your taxable capital gain with a capital loss. Both capital gains and capital losses are categorized as either short-term (for an investment that you've owned for one year or less) or long-term (for an investment that you've owned for more than a year), which means that almost every sale will create one of the following four results:

  • long-term capital gain (LTCG)
  • long-term capital loss (LTCL)
  • short-term capital gain (STCG)
  • short-term capital loss (STCL)

You net these out with the following three steps:

  1. Net your LTCGs against your LTCLs
  2. Net your STCGs against your STCLs
  3. Net your long-term result against your short-term result to arrive at a single taxable figure

Example: In one year, Sam sold several investments in his taxable accounts, resulting in:

LTCG: $11,000

LTCL: $6,000

STCG: $5,000

STCL: $6,000

He nets them out as follows:

  1. LTCG $11,000 and LTCL $6,000 _ LTCG $5,000
  2. STCG $5,000 and STCL $6,000 _ STCL ($1,000)
  3. LTCG $4,000

This long-term gain then receives the preferential long-term capital gain rate. However, if the netting process resulted in a capital loss, up to $3,000 can be deducted against ordinary income. Any amount over $3,000 can be carried over as a deduction in future years.

CAUTION: If you decide to sell a stock or mutual fund to take a tax loss, but you know that you want to buy it back at a future date, watch out for the wash-sale rule. If you sell a security at a loss and buy the same or a "substantially identical" security within thirty days, the loss is generally disallowed for tax purposes.

SMART MOVE: If you make a partial sale, your broker is required to report the cost basis for stocks purchased after January 1, 2011. The default method is FIFO, or "first in, first out." Instead, you may be able to minimize taxes by specifying shares with a higher cost basis.

Plan Your Charitable Gifts with Taxes in Mind

As you plan charitable contributions, there's no harm in lowering your tax bill at the same time. For example, think about the following:

  • You can deduct up to 50 percent of your adjusted gross income for contributions to qualified charitable organizations.
     
  • Give appreciated stock instead of cash. If you donate appreciated stock that you've owned for more than a year, this can be a win-win for you and the recipient. If you sell appreciated stock, you will owe capital gains tax. But you can gift the stock tax-free to a qualified charity plus receive a charitable tax deduction equal to its full market value. Caution, though: If you've owned the stock for one year or less, it's considered a short- term holding and you'll be able to deduct only the purchase price, not the full market value.
    • Conversely, it's better to sell depreciated stock before you donate the proceeds. This way you can realize a capital loss, which you can either use on your current year's taxes or bank for future years. Plus, you can still claim the value of the gift as a charitable deduction.
       
  • If you're 70½ or older, you can make a direct contribution to a charitable organization from your IRA without paying any tax. The downside is that you can't also claim a charitable deduction for this donation. However, it can count toward your RMD.

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