Plus, how your bracket and state of residence may affect you.

April 07, 2021
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Your retirement is an important personal and financial milestone. The earlier that you start saving, the more money you will have available when you are ready to retire. You can save money in different types of accounts, but most people choose to have their retirement savings in either 401(K)s, IRAs, or pensions. "Normally, traditional 401(k) distributions in retirement are taxed as ordinary income," explains Jill Gonzalez, analyst at WalletHub. So, how are taxes determined and can you lower your future tax bill for retirement?

retired couple filling out tax forms
Credit: atleho Seisa / Getty Images

The amount of income taxes that you pay will depend on several factors, including when you retire and when you withdraw the funds. "Early withdrawals come with an automatic withholding of 20 percent in taxes, as well as a 10 percent penalty from the IRS when you file your tax return. Roth 401(k) distributions are not taxed, because the contributions were made after taxes," she says. Ahead, we delve into the details.

The Best Methods

First, determine your expected tax bracket in retirement. The IRS has specified that income levels for each tax bracket, which means that amounts within one level are taxed at a particular amount and then amounts in other brackets are taxed at those levels; it is not a flat tax rate. Your tax bracket will depend on the annual amounts that you will have distributed to you when you retire. And a higher tax bracket means a higher marginal tax rate for those distributions. So, how can you lower your future tax bill (or at least prepare for it)? "There are several ways to save on taxes in retirement. For example, if you contribute to a Roth 401(k), all your distributions in retirement are tax free, because you contribute after tax money," Gonzalez says. "Another way to save on taxes is by withholding withdrawals as long as you can if you are still working, and definitely not making any early withdrawals."

Another way to save on taxes in retirement is to take a lower distribution of your retirement funds in the future. This could place you in a lower marginal tax bracket, which means a lower income tax bill. Of course, some accounts may have required minimum distributions (RMDs) so you will need to take that into account. These RMD amounts are updated every year and ensure that retirement funds are being used in retirement and not just as a means to avoid paying taxes.

State by State Retirements

And finally, if you want to save on income taxes for your retirement distributions, head to Florida. "Retirees can consider moving to a state where there is no income tax, such as Florida, Nevada, South Dakota, or Texas, among others," explains Gonzalez. The sunny weather is not the only reason that so many people choose to retire in these states. Tax benefits like no income tax on retirement distributions is a huge draw for many people. If you can afford to move and like these states, then this is one option for saving on retirement.

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