Reducing the amount of tax liability on your investments and retirement accounts is often priority number one among investors. There are a variety of strategies you can utilize to help reduce the amount you pay in retirement, once you reach that point in your life. Taking as many deductions and credits on your tax form as possible and maximizing your passive income opportunities are steps in the right direction. Fully understanding your investment options is crucial in order to maximize your tax benefits. However, there are some additional steps you can consider utilizing in order to fully capitalize on your tax savings once you reach retirement.
Utilize a 401(k)
There are many opinions on which retirement accounts offer the most advantages with regard to tax savings. One ideal option is to invest in different types of accounts in order to gain the most flexibility. You can save even more by contributing via payroll deduction because less money is withheld for income tax purposes.
If you are unable to contribute to a Roth 401(k), you will have to rely upon a traditional 401(k), for which the tax set-up is treated differently. A Roth 401(k) allows you to contribute after-tax and withdraw a tax-free balance once you retire.
Choose Tax-Efficient Investments
How you pay taxes on your investments each year largely depends on the type of investments you're working with. The returns on diverse investments are treated differently with regard to taxes. Investments held in taxable accounts must be watched carefully, as they can easily produce a high tax bill. Unless you plan to have a financial planner watch your taxable accounts very closely, choosing tax-deferred or tax-free accounts would be advisable. Examples of these include mini bonds and low turnover funds.
Pay Attention to Withdrawals
One major mistake some make is withdrawing from their retirement fund too soon. People often do this to pay off debt, make a large purchase, or to invest in passive income opportunities. However, early withdrawal before age 55 for 401(k) accounts often results in costly penalties. If you were planning to utilize an early withdrawal to pay for certain expenses, there are ways to avoid a penalty. To prevent this penalty, only utilize your retirement accounts for permitted expenses, such as using IRA distributions to pay for college, to purchase a home, or pay for unusually high healthcare costs.
Conversely, you must withdraw by a certain age, or you could also face a penalty. Withdrawals from IRAs and most 401(k)s are required after age 70 ½. Income tax is also due on these withdrawals with a penalty assessed for failing to withdraw the correct amount.
Live in a Tax-Friendly State
A unique method to reducing taxes on your retirement accounts is to live in a state that is tax-friendly. States that have no income tax—including Florida, Texas, and Nevada—are very attractive because they offer a significant savings on tax day. States with no sales tax often have lower cost-of-living expenses, including property and sales tax. While moving your life to save on your tax bill may seem extreme, it is a viable option for those who will take all measures to avoid stiff taxes.
Utilizing some of these strategies can greatly reduce the amount of tax liability you can expect come tax time. By investing carefully and diversifying to include passive income opportunities, your chances of significant tax obligations are greatly reduced. Also, consider annuities as part of your retirement plan.