Minimizing retirement taxes

Eric Tyson for Trib.com writes: The following excerpt comes courtesy of Bob Carlson, publisher of the "Retirement Watch" newsletter and my co-author on the book, "Personal Finance For Seniors For Dummies": 

Most retirement tax planning and discussions have the wrong focus. They look at marginal tax rates -- the rate on the next dollar of income earned. If you're married and earning $50,000 annually, for example, your next dollar will be taxed at 15 percent.

That's a fine approach during the working years of most people. For retired people, some self-employed people and a few other taxpayers, that's the wrong approach. Different types of income are taxed according to different schedules and at different rates.

A better approach is to focus on your effective tax rate. This is the percentage of all your income that is paid in income taxes. Many retirees can structure their income so that the effective tax rate is lower than the rate they pay during their working years. By making adjustments in investments, retirement-plan withdrawals and other income sources, a savvy retiree can keep his or her effective tax rate around 15 percent without reducing income.

For married couples filing jointly, ordinary and earned income is taxed at the 15 percent rate until taxable income exceeds $72,500 in 2013. (For single taxpayers the ceiling is $36,250.) Qualified dividends and long-term capital gains are taxed at the maximum 20 percent rate, regardless of their amount. For taxpayers in the 15 percent or lower marginal income-tax bracket, long-term capital gains and dividends are taxed at 0 percent. In the 25 percent and 35 percent tax brackets, long-term capital gains and qualified dividends face only a 15 percent rate.

Social Security benefits are tax-free until adjusted gross income reaches $32,000 for a married couple filing jointly or $25,000 for a single taxpayer. Distributions from Roth IRAs and interest from state and local bonds generally are tax-free.

Now, let's look at how you can use these features of the tax code to minimize your effective tax rate:

Wait to take Social Security benefits. As a general rule, delaying the benefits not only increases the amount of benefits, but also increases your tax-exempt income.

Defer traditional IRA distributions until you have to take them after age 70 1/2. Your nest egg lasts longer when taxable accounts are spent first. If you're still relatively young, consider the opposite approach, emptying your traditional IRA early by either taking a distribution or converting it to a Roth IRA. Simply taking a distribution may prove more favorable in the long run if you can then allow the money to grow and compound over an extended time (at least 10-plus years). Converting to a Roth avoids the forced IRA distributions after age 70 1/2  and the higher income taxes that come with them.

Make charitable contributions from your IRA. For 2013, the special tax treatment of charitable contributions from IRAs still applies. You must be over age 70 1/2, and the charitable contribution must be made directly from the IRA to the charity. You don't receive a deduction, but the distribution isn't included in gross income. This can be used for up to $100,000 for the year.

Seek tax-advantaged income in taxable investment accounts. Consider receiving some of your income from stocks or mutual funds that pay qualified dividends. Most U.S. corporate dividends qualify (though real estate investment trust distributions don't) and many foreign corporate dividends are qualified. For fixed income, consider purchasing tax-exempt bonds instead of corporate bonds or treasury bonds.

Manage taxable accounts to minimize taxes. Of course, you should avoid taking profits until you've held an asset for more than one year, if that makes investment sense, so the sale qualifies as long-term capital gain. Look for assets that have lost value. Sell them to capture the capital loss. It offsets capital gains for the year dollar-for-dollar and up to $3,000 of additional losses offset other income. Any excess losses can be carried forward to future years to be used in the same way.

Don't let the tax code alone dictate your financial strategies. Be sure that an investment or strategy really is more attractive after considering its after-tax effects.