Over the last few decades, retirement planning, and even the very essence of what it means to be “retired,” has dramatically changed.
And while some of the “old” rules of retirement still apply, those looking to enjoy a comfortable retirement in today’s world often need to buck old trends.
Case in point... in the past, the old adage was that, in general, during your working years you should put as much money as possible into your 401(k) and tax-deductible IRA to save for retirement and lower your tax bill.
The idea was to get a deduction during your working years, when your tax rate was higher, and to later take that money out of your tax-deferred accounts in retirement, when your tax rate was lower.
For some, that’s certainly still true today, but for many others, the reality is that retirement will bring with it a higher tax rate. In such situations, old-school tax-deferral strategies are less effective, and may even be detrimental to your long-term retirement success.
There are a number of reasons your tax rate might be higher in retirement than it is today.
Take, for instance, the Tax Cuts and Jobs Act, passed last December, which temporarily lowers taxes for most Americans through 2025. If no changes occur before then, however, we’ll see a reversal of that trend, and many Americans will see higher taxes in 2026, even if their income remains the same.
Another reason you might see your taxes increase in retirement is that there are certain “taxes” in retirement that don’t exist earlier in life.
The word “taxes” is in quotations there, because not all of the income-related costs you might incur in retirement are technically “taxes.”
But who cares what it’s called?
If the cost goes up as your income does, it goes down as a tax in my book!
One example of this is the Medicare Part B (and D) premiums you typically begin paying at 65.
If your income is high enough, you’ll be assessed with something called an income-related monthly adjustment amount, or IRMAA for short.
This is just a complicated way of saying you pay a higher premium because of your income.
In 2018, married couples filing a joint return begin to be impacted by the IRMAA at $170,000 of modified adjusted gross income (MAGI), and single filers are impacted with MAGI half that amount.
The top IRMAA level for 2018 takes effect at $320,000 of MAGI for joint filers, and can increase a married couple's combined Medicare costs by nearly a whopping $9,000!
Other income-related costs (taxes) that you might be subject to in retirement, and aren’t applicable earlier, include taxes on Social Security benefits, which generally can’t be claimed until as early as 62.
The formula to determine the taxation of Social Security benefits is particularly complex and failing to understand those complexities could be costly.
For instance, thanks to an oddity that’s been nicknamed the “tax torpedo” by some, it’s often less tax efficient to pay tax on IRA distributions at a 10% rate after beginning to receive Social Security benefits than it is to pay tax on IRA distributions at the higher 12% rate before beginning to receive Social Security benefits. If that doesn’t make any sense, don’t worry. It’s not supposed to.
We’re talking taxes here, after all.
There are plenty of other reasons to believe that both your “taxes” and your taxes might be higher in retirement too.
Consider the potential cost of losing out on lower property tax rates that are sometimes available to seniors with more modest incomes in some jurisdictions.
And remember that at 70 ½ you must generally begin to take distributions from your pre-tax retirement accounts – whether you want to or not - which can quickly drive up your taxable income. And what tax rate will you pay then? Who knows?! It could depend on which way the political winds are blowing at the time.
All of this, again, is to make the point that just because you’ve always been told you’ll be in a lower tax bracket in retirement doesn’t necessarily make it so.
This trap has caught many off-guard over the years, leading to needless taxation.
Don’t let it happen to you.
By looking ahead and planning now, you can take proactive steps to maximize the efficiency of your income in retirement, such adjusting deferrals to 401(k) and similar plans to utilize the Roth options, when available, exploring Roth IRA conversions, considering the built-in tax efficiency of Social Security benefits relative to most other income streams, and re-evaluating asset location plans.