Top Tips 2020 – Income Tax During Retirement: It Still Exists!
Article provided by Jason C. Gaynor Investment Services, LLC
It’s the goal that we all have—a happy retirement. No more stress from work, no worries about bills because we have no debts. You saved diligently, you deferred a portion of your salary into your 401K or IRA, and now the time has come to enjoy living off of your savings.
What happens when one begins distributing those funds, taking income during retirement? Since every dollar in the traditional IRA or 401K has never been taxed, every dollar that comes out will be subject to ordinary income tax, and this is where more often than not, we discover some cracks in our planning.
A common statement that many individual have been told is “During retirement I will be in a lower tax bracket, so I will be fine,” This is a baffling statement; was your plan really designed for you to lower your income when you finally have time to enjoy and spend? Why would one set a retirement goal of living on 50-70% of our current income level? Realistically, most of us will continue to require 85-90% of our current income to live comfortably in retirement, and we need to plan on remaining in a similar income tax bracket.
Now comes the great mystery, taxes are at a historic low threshold today, what will they look like in the future? How much income will you lose to taxes? If you act now, can you mitigate the impact of taxes, and potentially, eliminate it completely?
Let’s first examine the impact of taxation at today’s tax rates. For example, Jane, a single individual, with $750,000 in a traditional IRA, earns income from Social Security of $30,000 per year, and takes income of $41,000 per year from her IRA, annual income of $71,000. Taxes are $12,000 per year for a net after tax income of $59,000. Here is the breakdown:
Gross Income: $71,000
Effective Tax Rate: 16.9%
This seems reasonable enough in today’s low tax environment; Jane’s effective tax rate is only about 17% for both Federal and State taxes. However, Jane’s decides she would like to help her son open his own business, and decides to take out an additional $60,000 from her IRA. The impact to her taxation is quite dramatic:
Gross Income: $71,000 + $60,000 = $131,000
Tax: $15,900 + 13,440 = $29,340
Net: $55,100 + $46,560 = $101,660
Effective Tax Rate: 22.4%
This distribution boosts Jane into a higher tax bracket, now her taxes on her living income of $71,000 are nearly $16,000, and the tax on her $60,000 distribution to help her son are over $13,000. The $60,000 distribution from her IRA cost Jane $17,340! To make matters worse, she still needs to make up for the $17,340 in taxes. Jan then increases her distribution from $60,000 to $80,000, having $20,000 withheld for taxes. Unfortunately, this $20,000 withheld for taxes is also a distribution, and is therefore, you guessed it, subject to income taxation, meaning this tax withholding will cost Jane another $6000 as she bumps her effective tax rate now to 23.4%.
With this example we clearly see that taxes can snowball quickly when we take lump sums of pretax retirement plans. As challenging as this example seems, one must consider that with the passage of The Tax Cuts and Jobs Act of 2017, most of us are experiencing the lowest Federal tax rates ever in our lifetimes. To put today’s low tax rates into perspective, consider these marginal tax rates for a married filing jointly taxpayer:
In 2020 earning $75,000: 12%
In 2020 earning $160,000: 22%
Now, take a look at what tax rates used to look like:
In 1967 earning $8,000: 22%
In 1967 earning $12,000: 36%
In 1974 earning $16,000: 28%
In 1974 earning $32,000: 42%
In 1982 earning $20,200: 28%
In 1982 earning $45,800: 49%
In 1994 earning $38,000: 28%
In 1994 earning $91,850: 31%
What will Federal tax rates look like during your retirement? This is an unknown, yet it is clear from a look at past tax rates that higher rates in the future is not only possible, but an expectation. The impact could deeply erode your spending power during retirement significantly. The good news is that you can take steps today that could save you potentially thousands, if not hundreds of thousands of dollars in taxes in the future.
Roth IRAs and Roth 401K plans provide opportunity for tax free income in retirement. There is a catch—as traditional IRA and 401K plans provide an upfront tax benefit, with your deferral into a Roth you will receive no upfront tax deduction; in short, you will pay taxes at today’s low rates, and enjoy tax free income during your retirement.
Certainly every individual is different; age, tax status, and income level are key considerations in deciding what plan is best for the individual. Talk to your financial advisor to gain some education regarding your planning; modifications are much easier to make early than late in the game and can save you from a less than stellar retirement.
This article does not constitute professional and/or financial advice, and Jason C Gaynor Investment Services LLC is not fiduciary by virtue of person’s access to article. Please consult your financial advisor and/or tax professional for personal guidance relating your individual financial position.
Jason C Gaynor, Registered Representative offering securities, through NYLIFE Securities, LLC, Member FINRA/SIPC, a Licensed Insurance Agency, 7500 College Blvd, Ste 800, Overland Park KS 66210 913-451-9100. Jason C Gaynor Investment Service LLC is independently owned and operated from NYLIFE Securities LLC and its affiliates.