Paying taxes is not pleasant but important responsibility for everyone. In US, the tax code designed to take the most advantage of people working for a company in private sector. Pretty much all their income is eligible for ordinary income tax, and there is not much you can do with that. The topic become more interesting for people who own business or retired. The focus of this article is on retired folks, who collect their income from pension, retirement accounts or investment.

Indeed, retirement accounts such as 401K or IRA are designed to take advantage of lower tax rates applied when you retire. It is assumed there is no earned income anymore. Some may suggests many retired people still has a substantial tax burden and have to pay high tax. While it may be true to some extent, it is important to realize that there are legitimate ways to reduce the tax at retirement. Moreover, there are greater opportunities of doing that, compared to working years.

With respect to tax, it is important to consider the overall tax burden. Which typically include individual income tax (federal, state and local), sales tax and property tax at least. Let us focus on federal tax first. Since we assume that the retired individual does not have earned income, the following strategies can apply:

• Use Roth IRA distributions when possible
• Limit traditional IRA or 401K distributions or offset them by tax deductible spending
• Make sure taxable accounts provide tax efficient income

In order to get advantage from tax-free Roth IRA distributions, it is important to have sufficient funds in it. There are multiple ways to fund Roth IRA. While direct contributions are limited by $6,000 annually (or $7,000 for those older than 50), there are backdoor Roth and mega-backdoor Roth conversions providing more flexibility. For example, conversion from employer’s after tax 401K account could reach as much as $34,500 annually. However, in case of conversion it is important to remember about 5 years rule which essentially prohibit Roth IRA gain distributions for 5 years after the conversion time.

There is an ordinary income tax always applied to Traditional IRA or 401K distributions. We cannot do much about it, but it is possible to limit amount of money converted each year to minimize tax or completely avoid it. For example, first $12,400 (single) or $24,800 (married couple) matching standard deduction can be converted without any tax withheld. Also funds coming into Health Spending Account (HSA) are tax-deductible too. As discussed in previous article health care expenses can be deducted as well after certain limit has been reached. But in certain situation too little income may actually be worse: in order to qualify for ACA subsidy for those younger than Medicare age, Modified Adjusted Gross Income (MAGI) must be at least 138% of Federal Poverty Level which is $17,609 (single) or $23,791 (couple). This link gives some idea how MAGI is calculated.

Income received from taxable accounts can be managed too. For long term capital gain (stocks sold after one year since acquisition) there is a special tax treatment: currently income below $40,000 (single) or $80,000 (couple) is actually tax-free. The same is applicable to qualified dividends available from certain stocks. Is it necessary to buy individual stock, in order to receive special tax treatment? Not at all. But everyone needs to be careful about income distributed by actively managed mutual fund or ETF, to align it with tax strategy. For example, these are year-end distributions per share made in year 2020 by Vanguard Wellesley fund: long term capital gain $0.388, short term capital gain $0.078, dividend $0.192. Apparently Certificate of Deposit or Savings account are the worst in terms of income tax: ordinary income tax is always applied.

Pretty much all remaining taxes depend on the place where we live. The high level picture on overall tax burden by state can be found for example here. The tax in the table has ranking from the highest in New York, Hawaii, Vermont to the lowest in Tennessee, Delaware, Alaska. But local tax may vary between the counties within a single state. Considering state and local income tax, it may be worth to check if there is a flat or progressive tax rate. The flat state tax rate vary from 3.07% in Pennsylvania to 5.25% in North Carolina with Indiana, Michigan, Colorado, Illinois, Massachusetts and Kentucky in between. Although reasonably small, it may be higher for low income people than in some states with progressive tax rate. The difference between the tax applied to high and low income earners may be as high as 9.3% (California), 7.2% (New Jersey) or 5.4% (Vermont). Income tax in these states starts from 1%, 1.4% and 3.35% respectively.

It is hard to manage sales tax. If it happens to be high, the only way to reduce it is to buy less. Still, there may be some strategy to help. The Payboo credit card actually pay sales tax back to buyer, when purchase happens online at their website bhphotovideo.com. It may be worth to buy expensive cell phones, tablets or computers there for those living in area with high sales tax. How about even bigger ticket items like a new car? It is possible to buy a car in one of the states without sales tax on cars and register it in other state after 90 days from purchase. Besides that, there are states with no sales tax: Alaska, Delaware, Montana, New Hampshire, Oregon. Also there are states with low sales tax, such as Hawaii, Wisconsin, Wyoming and Main.

Many retired people consider moving into states with no income tax: Washington, Nevada, Texas, Florida, Tennessee, New Hampshire, South Dakota and Wyoming. While it make sense for some, the states with no income tax often take the revenue from other sources such as sales or property tax. For example, the state of Oregon does not have sales tax but income and property tax are on the high side. Meantime the state of Nevada has no income tax and relatively low property tax, but sales tax is high. Again, it is worth to look into overall tax burden, rather than just income tax. Property tax combined with other local taxes can make retirement life miserable. Therefore, it is important to understand what tax breaks are available for retirees. The guide like this can be used as initial guess.