One of the most common mistakes I see people make is overestimating their tax rate in retirement. This is important for a couple of reasons. First, as Roth 401(k) and 403(b) plans become more common, estimating your future tax rate is a big factor in deciding whether you should make Roth or pre-tax contributions. Second, your tax rate is used to estimate your after-tax retirement income in determining how much you need to save. Let's take a look at some of the reasons why your tax rate in retirement will probably be lower than you think:
Not all your retirement income is taxable
When you're working, the bulk of your income is from your job and is fully taxable (after deductions and exemptions) at ordinary income tax rates. When you're retired, this is only true for pension income, withdrawals from taxable retirement accounts, and any rental, business, and wage income you have. Social Security is taxed at ordinary income rates, but only part of it is taxable. Withdrawals from Roth accounts are tax-free if you've had the account for at least 5 years and are over age 59 1/2. Accessing the principal from savings and investments is tax-free and long-term capital gains are taxed at lower rates or can even reduce other taxes if you're selling at a loss.
Your income will probably be lower
Experts typically estimate that you need about 70-80% of your pre-retirement income in retirement, but you may need even less depending on your situation. How much of your income goes to saving for retirement and paying into Social Security? Do you have a mortgage and other debts that will be paid off? Do you have kids that will no longer be financially dependent on you? Are you thinking of downsizing or moving to a lower-cost area?
When you add all this up, you may find that you need less than 80%. If your income is lowered enough, you may retire in a lower tax bracket. But even if you retire in the same tax bracket, your effective tax rate may be lower. Here's why....
Your effective rate is what matters in retirement
First, what do we even mean by "tax rate?" When you're contributing to a retirement account, you probably want to look at your marginal tax rate. That's the tax rate you pay on an additional dollar of income. The reason is because the next dollar that you contribute to your retirement account would normally be taxed at the marginal tax rate.
Let's say I'm a single person with a taxable income of $50k a year. That puts me in the 22% marginal tax bracket for 2021. But according some calculations, my effective tax rate would be 13.5% of my taxable income since only my taxable income over $40,525, or $9,475, would be taxed at that 22% rate. The rest would be taxed at 12% or less. However, if I contribute $7k to my 401(k) pre-tax, all of that $7k would normally be taxed at the 22% rate.
Now, what happens when I take money out of my 401(k) in retirement? First, some of my income won't be taxed at all because of deductions and exemptions. In fact, my standard deduction would be $1,700 higher if I were age 65 or older this year.
The first $9,950 of taxable income would only be taxed at 10%. Then the next bucket of income up to $40,525 would be taxed at 12%. Only the income over $40,525 would be taxed at the 22% rate. Unless I'm retiring with a large pension (which is rare these days), a lot of those 401(k) contributions will probably be taxed at the lower rates.
You also want to use that lower effective rate when you're estimating how much of your retirement income will go to pay taxes. Unfortunately, too many financial plans use the higher, marginal rate. While that's a more conservative assumption that could motivate you to save more, it could also discourage someone from thinking that they could ever retire.
For example, a couple I spoke with didn't think they would have enough income to retire. However, they were assuming that 22% of their income would go to taxes because their retirement income put them in the 22% tax bracket. But when I estimated their tax bill in retirement, it ended up being only about 4% of their income since Social Security was such a large percentage of their income and only half of it was taxable at all. (See the first point.) That 20 percentage points made a huge difference for them.
You may retire in a lower taxed state
Many states are very tax-friendly for retirees, while some popular retirement destinations like Texas, Florida, and Nevada don't even tax income at all. When you do the math, you'll see that warm weather isn't the only thing some states have going for them.
For all these reasons, you may be overestimating your taxes in retirement and hence underestimating your take-home retirement income. Fears of higher taxes could also bias you towards Roth rather than pre-tax retirement plan contributions. It may be a good idea to scare yourself into saving more or to make Roth contributions, but higher taxes in retirement isn't necessarily the best reason to.
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