5 Ways to Lower Your Tax Bill in Retirement

A. I'm worried about paying taxes when I stop working, since I may be in a higher bracket. What are the best strategies for reducing my tax bills in retirement?

Q. It’s a good question, and it's one you need to focus on well before you retire. “Overall, the way to reduce taxes in retirement is to plan ahead,” said Levi S. Brandriss, a certified financial planner in Bethesda, Md. These five moves can help fend off Uncle Sam.

1. Opt for a Roth 401(k). Check to see if you have access to a Roth 401(k) on the job, which lets you save after-tax money that grows free of taxes. If so, you may be able to do what’s known as an in-plan conversion and roll over part or all of your pre-tax 401(k) savings into a Roth 401(k). The downside is you’ll owe taxes—at ordinary income rates—on all the pre-tax contributions to your account. That could be a large amount if you've only been contributing on a pre-tax basis. The upside is that you may still come out ahead with a conversion.

Here's why: Once you hit age 70½, the IRS mandates that you take required minimum distributions (RMDs) from any traditional 401(k) or IRA accounts, and these distributions are counted as taxable income. This is Uncle Sam’s way of finally getting his share of the savings that have grown tax-deferred for decades. The distributions could bump you into a higher tax bracket and also increase your Medicare Part B premiums, which are tied to income. So reducing the size of your RMDs can make a big difference to your tax bill.

But there are two caveats: This move only makes sense if you have the cash on hand to pay the tax bill, and you're certain your tax rate won't fall in retirement. So this strategy isn't right for everyone.

2. Do a Roth IRA conversion. A similar move for those with savings in a Traditional IRA is to do a Roth IRA conversion—by shifting some of your money out of your pre-tax account into a Roth, you can reduce your future RMDs. If you don't have a Roth 401(k), it may be your best option for creating a cushion of tax-free savings. But the same caveats noted above apply here.

3. Donate IRA savings. Another option for those with traditional retirement accounts, assuming you don't need the money, is a qualified charitable distribution. The IRS allows taxpayers to donate up to $100,000 annually from their Traditional IRAs, as long as the money is sent directly from the IRA trustee to charities. These donations can reduce your RMDs, but they do not qualify for a charitable deduction.

4. Save in tax-efficient accounts. Beyond these individual moves, it's important to pay attention the bigger picture: Are you choosing the right type of accounts for your investments? Opting for the right tax location can help trim your tax bill. Your 401(k), IRA, or other tax-advantaged accounts are best for sheltering investments that generate income or significant short-term capital gains, such as taxable bond funds, real estate investment trusts, and actively managed funds. For assets that pay fewer taxable distributions—such as municipal bonds, individual stocks, low-turnover stock funds and exchange-traded funds—you can opt for a taxable brokerage account.

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5. Move to a low-tax state. Instead of just moving their money around, some retirees move residences to lower their costs. Florida has long been a popular retirement destination, thanks to its warm climate and its lack of a state personal income tax. But the best location for you may be elsewhere. It's important consider your total expenses in a new destination, not just taxes, says Brandriss. Your dream house on the ocean might come with sky-high homeowners’ insurance bills, while states without an income tax may levy high sales taxes or other fees, according to Brandriss. You will also want to consider how well the location will meet your needs as you age.

The upshot? The tax rates in an individual state may have less of an impact on your retirement security than your overall cost of living. And in the end, financial considerations should not be the driving factor in a decision to relocate—family, friends and climate also matter. Says Brandriss, “Obviously, you have to want to move to Florida.”