Why You Might Be in a Higher Tax Bracket During Retirement
A common piece of advice is to max out your pre-tax 401(k) while you work. You'll get a tax break now and then pay taxes on the money during retirement when you'll be in a lower tax bracket.
But, is that actually true?
Well, maybe.
Income during retirement?
Many people assume that after they leave their job, they won’t have much income to report on their tax return anymore. That’s not true for most people. Income can come from many sources during retirement, for example:
A part-time job
Social Security benefits
Pension benefits
Selling investments in taxable accounts
Withdrawals from pre-tax Traditional IRAs and 401(k)s
It’s that last bullet that can surprise people.
If your living expenses are low enough, you very well may be in a lower tax bracket during the initial years of retirement. That’s good!
The problem is that something called required minimum distributions (RMDs) are lurking.
What are required minimum distributions (RMDs)? And why must they lurk?
According to today’s tax law, the government will force you take withdrawals from your pre-tax accounts, such as most IRAs, 401(k)s, 403(b)s, etc., starting at age 72.
They do this through required minimum distributions (RMDs). That is, you are required to take a minimum amount of a distribution each year.
The government does this because, well, they want to get paid.
As you may know, when you make contributions to these types of accounts during your working years, you get a tax deduction. That is, the government isn’t collecting any taxes on that amount of your income (since you’re contributing it to one of these accounts).
The government lets these accounts grow over time without taking out any taxes along the way either. For this reason, pre-tax accounts are very powerful and can be great savings vehicles.
However (there’s always a however isn’t there?), the government gets their cut when you finally withdraw the money from the account. And the government wants to make sure it gets paid at some point, so they require people to start taking withdrawals at a certain age. That age is 72 right now. (It was 70.5 a few years ago, and there’s currently proposed legislation that may change it to 75.)
When you reach age 72, you have to take these RMDs. The RMD amount changes each year, as it’s calculated according to your age and the balance of your account(s) as of the end of the prior year.
So, why would I be in a higher tax bracket?
The issue is that these RMDs may very well push you into a higher tax bracket. They count as income on your tax return. And, remember, you have to take them whether you need the money or not.
So if your IRAs/401(k)s are big enough, that could make your RMDs big enough to make it so that your income is actually higher than when you were working.
Nice problem to have, right?
Well, yes and no. It’s great to have so much income. But it also might mean paying a lot of taxes.
Can you give me an example, please?
Let’s take a fictional couple, Mr. & Mrs. Fictional, with the following situation:
Ages 60 and 59. Both will retire at age 65.
Combined salary: $300,000
Monthly expenses before taxes: $15,000 now; $12,000 during retirement
Pre-tax Traditional 401(k) balance: $1,500,000
Pre-tax Traditional IRA balance: $400,000
Taxable brokerage accounts & bank accounts: $500,000
If we play out this situation making various assumptions on investment returns and tax rates, Mr. & Mrs. Fictional will indeed be in a lower tax bracket when they retire. But when those RMDs kick in at age 72, their tax bracket goes up. That means, all things being equal, higher taxes.
Here’s a chart that shows the projected marginal tax brackets for Mr. & Mrs. Fictional (with Mr. Fictional’s age along the bottom on the X axis):
If you’re not good with charts :-), the quick summary is:
Their current tax bracket as they are working is 24%.
It is projected to dip down to 15% during the initial years of retirement.
It is projected to jump up to 28% and then 33% (and then eventually 39.6%) when RMDs start.
So this is an example where our fictional couple, despite making quite healthy salaries while working, end up in a higher tax bracket during most of retirement as compared to their working years.
What can be done?
Mr. & Mrs. Fictional might consider a few things to help reduce their lifetime tax bill:
Consider switching their 401(k) and IRA contributions from Traditional to Roth (which would switch them from pre-tax to after-tax).
Consider taking bigger withdrawals from their pre-tax Traditional IRA/401(k)s during those initial retirement years.
Consider doing Roth conversions.
Consider deferring Social Security for as long as possible, spending from their pre-tax accounts instead.
Some of these actions could literally save Mr. & Mrs. Fictional tens-to-hundreds of thousands of dollars.
What should I do with this info?
That’s hard to say. The tax scenario you’re seeing above may or may not rhyme with your financial picture. It all depends on your specific tax, investment, and retirement situation.
I highly encourage you to work with a financial planner who can help you understand your projected numbers and to come up with a plan reduce your lifetime tax bill.
I’d also like to humbly suggest that you be proactive with this stuff. If Mr. & Mrs. Fictional waited until age 72 to start worrying about their taxes, it would be too late. It’s much better to start to make a plan ASAP, before retirement starts … in fact, the sooner the better.
If you’d like to have a conversation with me about it, click the Start Here button on this website to set up an Intro Conversation.