If you ran into Uncle Sam these days you would see he is looking pretty tired. The national debt he has been carrying around is growing larger and larger and its weight is becoming overwhelming. In the past ten years, our national debt has grown by over $10 trillion to an all-time high at just under $17 trillion. If that is not scary enough, even with the recent spending cuts and tax increases, our debt is expected to rise to over $20 trillion by 2017. No matter what side of the political isle you sit on, it is obvious that we have a huge problem. So what options do we have? To put it simply, it boils down to two solutions: increase tax revenue or reduce spending. (In all reality, due to the incredible size of the problem, a combination of both options is likely needed.)
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With this issue on the horizon, the question we need to be asking is how this tax problem could impact you during retirement. According to the 2010 US Census, the average income for households ages 55-64 is $78,691. As individuals begin to retire, the average income drops to $50,121 for households over the age of 65. That is more than a $28,000 decrease in income which should mean less tax, right? Not so fast. With the prospect of rising tax rates, some retirees could find themselves paying even more in taxes than they did when they were working. How can this be? A look at the history of our country’s tax rates will reveal the answer.
A Little History Lesson
In 2002, one of the largest tax cuts in our history went in to effect creating a new 10% tax bracket and lowering taxes across the board. Originally these tax cuts were set to expire in 2010 but were extended until 2012 and then made permanent as part of the “solution” Congress put in place as we stared down the fiscal cliff at the end of 2012. Beginning in 2013, only those in the highest income bracket received a tax increase.
As we discussed earlier, with the increasing deficit our country is facing, an increase in tax rates on more than just the top tier is not only possible, it is likely unavoidable. While it may be difficult to predict the changes to our current tax rates, it would not be unrealistic to assume that our tax rates would look similar to the levels we had before the Bush tax cuts went into effect.
Using this assumption and the Census data above, today an average working couple making $78,000 a year would be in a 25% tax bracket. If this couple retired and their income dropped to the average of $50,000 a year, they would drop down to a 15% tax bracket. The kicker is that if tax rates switched back to the rates prior to the Bush tax cuts, there tax bracket would jump up to 27.5%! In this highly plausible scenario, even though our couple’s income dropped by over $28,000, their tax rate would have actually increased which should make you sick to your stomach.
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Steps to Maximize Your Tax Efficiency
So what steps can you take now to avoid this potential issue? There are a several options to consider that will allow you to proactively address this issue and optimize your financial plan.
- Tax-Deferred Contributions: As you contribute funds into your 401k or IRA plan, you are deferring the taxes on those funds to some point in the future. Depending on your current tax bracket, it may be better to pay the taxes now on those contributions rather than deferring taxes to a time when tax rates may be higher. With that being said, if your employer matches a percentage of your contributions, make sure you contribute enough to take full advantage of the “free money” they will contribute into your account. For example, if your company matches 3% and you are contributing 12%, then redirect the unmatched portion (9%) into another tax free or after tax savings bucket.
- Roth Accounts: More and more employers are providing tax-free options inside of their retirement plans as long as you don’t make too much money. While you don’t get a tax write-off today, the contributions and growth will be tax-free when withdrawn during retirement. Having a tax-deferred account, a tax-free account (such as a Roth IRA), and a regular taxable investment account will give you flexibility as to where you pull money from to supplement your income in retirement. Depending on your income level and the tax rates at that time, you can determine which account to withdraw the money from to maximize tax efficiency.
- Conversion of Existing Retirement Accounts: Recently, most of the restrictions for converting funds from a tax-deferred account to a “tax-free” account have been removed. This means that you can convert your existing IRA and 401k accounts into tax-free vehicles where all future growth and withdrawals will have no tax consequences. These conversions should be done while taxes are low and at amounts that don’t push you into a higher bracket. For example, let’s assume you’re an average retiree with income of $50,000. This means that based on today’s tax rate, you could convert $22,500 from your tax-deferred accounts and still remain in the 15% tax bracket. By taking advantage of this opportunity, you are choosing to pay taxes today at likely a much lower rate rather than waiting and paying a higher tax rate in the future.
Take Advantage of the Opportunity
For those that have a majority of their retirement nest egg in taxable IRA, 401k, and other tax-deferred accounts, understanding how our current and future tax environments will affect you is critical. While it may be difficult to pay a little more in taxes today, it is much better than the alternative. When taxes increase in the future, those that took advantage of this opportunity will have a variety of accounts, both taxable and tax-free, that can be used to maximize tax efficiencies. Having these options available to you will give you the ability to appropriately adjust and adapt your financial plan during retirement.