The so-called “theory of decreasing responsibility” says that although many seniors will have decreased income levels when they retire, they will also have fewer expenses and lower taxes. I call baloney on both these ideas.
When clients come to me, they often believe that they will automatically be in a lower tax bracket because they are now retired. I’ve discovered that most of the time, this will not be the case because:
1. Many, if not most, retirees will no longer receive all the deductions they’ve been used to in the past.
These seniors may have homes that have paid off by the time they retire, or their homes are close to being paid off. That means they don’t get a mortgage interest deduction. Typically retirees won’t have any children to claim as dependents either. And, if they are no longer working, they don’t have 401k or other qualified plan contributions to help reduce taxable income. The net effect of all these factors is that many seniors’ entire income will be taxable during retirement.
2. Financial experts expect future tax rates may be higher than they are today.
For the 2022 tax year, the brackets are 10%, 12%, 22%, 24%, 32%, 35% and 37%. Historically speaking, tax rates now are pretty low, especially compared to the 1970s when the top rate for those earning $100,000 or more was 70%. The highest interest rate in the US was in 1944, when the top rate was a whopping 94%! When I consider the growing national debt, weak economic output, and near-bankrupt municipalities, I see taxes increasing.
3. The first few years of retirement can be expensive.
A retirement columnist I read once described retirement’s phases as: “Go-Go, “Go Slow,” and “No Go.” In the early years of retirement (Go-Go), people tend to indulge themselves, doing everything they never had time for when working. New retirees may go on road trips until the wheels fall off the RV, take up expensive new hobbies, go on cruises, or even start businesses. All of these endeavors take money. The idea that your expenses will go down, especially in the Go-Go phase, could be wrongheaded wishful thinking.
Another reason for making tax planning a cornerstone of your retirement blueprint is that depending on your “provisional income,” up to 85% of your Social Security will be subject to federal taxes. Many people don’t realize this and are surprised when they get their tax bills.
The IRS has a helpful calculator to let you determine your provisional income. Or, if you enjoy math, you can do it yourself.
1. Look at your modified adjusted gross income (MAGI)
2. To your MAGI, add half of your Social Security benefits.
3. Add in all tax-exempt interest.
If you’re married, filing jointly, and your provisional income is less than $32,000, you won’t pay tax on your Social Security benefits. Single people making $25,000 or less also don’t pay taxes on their benefits. Those married and earning between $32,000 and $44,000 in provisional income can have up to 50% of their Social Security taxed. For single taxpayers, income between $25,000 to $34,000 will trigger a tax on their Social Security benefits. As you can see, Uncle Sam tries to take back as much as possible when he “gives” you a break. Oh, and by the way, if you live in Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, Rhode Island, Utah, or Vermont, you may have additional state taxes on your Social Security check.
How can you protect your income against adverse tax situations when you retire?
Look into Roth IRA accounts
Distributions from Roth IRAs and 401ks aren’t taxed when you retire. As long as you adhere to IRS rules, you can withdraw as much money from these accounts as you want. You’ll have less tax stress if you put at least some of your retirement funds into Roth vehicles while you’re still working. Even better for some folks is to use Roth accounts as their primary retirement accounts.
You might choose a Roth if you think you could be in a higher tax bracket when you retire than you were while still working. Remember, though, that Roths give you no tax breaks up-front during the year you make contributions. Also, ask your advisor about the possibility of converting your traditional retirement accounts to Roths. A qualified plan “roll-over” process does have tax consequences and rules, such as the “five-year rule,” so you will need to understand both the benefits and potential pitfalls of this maneuver before you execute.
Move to tax-friendlier places.
If you live in a state not known for being easy on taxpayers, consider moving. A handful of states, for example, don’t tax income. Others don’t tax Social Security benefits.
Make more strategic withdrawals.
Besides the dreaded required minimum distributions (RMDs) you must take from certain retirement accounts, such as IRAs and 401Ks, you have a lot of flexibility in how and when you draw down your retirement accounts. For example, if you expect your income to be less in a given year, you might take more significant distributions from your accounts, so the money is taxed at a lower rate.
Add tax-free investments to your portfolio.
Pre-retirees ready for retirement often de-risk their portfolios, putting some funds into treasury or municipal bonds. Treasury bonds are usually exempt from both federal and state taxes. Municipal bonds are free from federal taxes.
Invest for the long haul.
Taxes on your investment income are either short-term or long-term capital gains rates. Long-term capital gains are treated more favorably than short-term gains.
Review and assess your investment strategy regularly.
Regular meetings with your advisor to review your portfolio are a wise idea.
In such an unpredictable and chaotic economic environment as we now have, it makes sense to meet more often with your advisor to ensure that unforeseen tax issues won’t keep you from reaching your retirement goals.
Ken’s Takeaways: Taxes are bound to go up. But that doesn’t mean your finances have to get battered. Don’t end up paying more in tax than is legally required! Nearly every senior’s portfolio can benefit from having a second set of eyes that can pick up on potential issues and help you create a more efficient tax plan. Contact my office if you’d like me to give you my honest, no-baloney assessment of your current retirement blueprint or if you need someone to help you start one.
Get more resources to help you turbocharge your retirement here: https://apexfg.com/resources/