For most people, retirement is a significant milestone. Some can’t bring themselves to stop working, but for others it represents a significant change in both income and lifestyle. Living in a high-cost area like San Diego can bring unique challenges, particularly regarding taxes. It’s essential for retirees — or those on the cusp of retirement — to engage in proactive planning to minimize taxes and ensure their financial well-being. Let’s explore how these planning strategies can help minimize taxes in retirement.
Understanding California Retirement Taxes
Navigating the intricacies of California’s tax system is crucial for retirees. While Social Security benefits are not taxed at the state level, other retirement income sources, such as pensions, 401(k) distributions, and IRA withdrawals are subject to California state income tax. California’s tax brackets are steep, meaning that income from things like required minimum distributions (RMDs) from retirement accounts can quickly push you into a higher state tax bracket.
On the other hand, it is possible to have a comfortable retirement in California without paying exorbitantly high taxes. By controlling how much taxable income is generated in retirement, you can keep taxes manageable.
Taking Steps Now to Reduce Taxes in Retirement
Here are some strategies which may help position you for a lower tax situation in retirement:
Roth conversions and mega backdoor Roth strategies. Roth IRA conversions allow you to convert traditional IRA or 401(k) funds into a Roth IRA. While this conversion is taxable in the year it’s made, the funds grow tax-free thereafter, and withdrawals in retirement are also tax-free. This strategy can be particularly effective in California, where high state taxes make tax-free income in retirement highly desirable.
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For those still working, the end of the year is a great time to consider the Mega Backdoor Roth strategy. It can be an excellent way to maximize retirement savings while minimizing taxes. This strategy involves making after-tax contributions to a 401(k) and then converting those contributions to a Roth IRA. The benefits of this strategy are significant, especially in California, but only if you’re temporarily in a lower tax bracket that you will be later on in life. For example, if you are in between jobs or can delay receiving income, Roth conversions at low tax rates can be a winning tax management strategy.
Charitable giving strategies. Consider making charitable donations or using Donor Advised Funds to lump several years’ worth of small donations into a single tax year. Not only does this support causes you care about, but it also provides tax benefits. Charitable contributions may be deducted from your taxable income, and year-end giving or lumping your gifts can be strategically planned to maximize tax savings. For retirees, using strategies such as Qualified Charitable Distributions (QCDs) from IRAs can be especially tax efficient.
How Can You Minimize Taxes on Retirement Income?
Keeping taxes manageable while retired in San Diego requires a comprehensive approach. Here are some strategies:
Strategic withdrawals. Plan your withdrawals from taxable accounts to minimize your tax bracket.
Utilize Tax-efficient investments. Some investments generate less taxable income and are therefore considered more tax efficient. For instance, income from most California municipal bonds is not taxable for California state taxes or federal taxes, so retirees who rely on income from these investments can receive tax-free income from them.
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Manage tax deductions. By timing and managing tax deductions, you can reduce your California state tax bill in retirement. Charitable contribution strategies are the best opportunity to strategically manage your deductions, reduce your taxable income, and benefit your community in the process.
Tax-loss harvesting. Use this technique to offset taxable capital gains with losses to reduce taxable income in retirement.
These are some of the basic strategies many retirees use to manage their taxable income in retirement. Remember, though, there is no free lunch. For example, charitable gifts are tax deductible, but you’re still giving away the money. And some tax avoidance strategies (like borrowing from insurance policies) often cost more than they’re worth.
At Blankinship & Foster, we specialize in creating an integrated plan focused on the financial and life outcomes you really want. We consider all the important pieces of the retirement puzzle, including taxes.
