The Bogleheads' Guide to Retirement Planning (27 page)

Income tax rates that you will pay when you withdraw tax-deductible funds in retirement are likely to be lower than the income tax rate that you saved when you made the contributions. There are two reasons for this: First, you are likely to find yourself in a lower marginal tax bracket in retirement, even if you spend just as much money. (In a recent survey, 45 percent of retirees reported that they spent less in retirement than before retirement, and 33 percent reported that they spent about the same.) Second, the withdrawals from your tax-deductible retirement accounts are likely to be spread across your lower income tax brackets, so that the effective income tax rate on the withdrawals will be lower than your marginal income tax rate when you made the contributions. The difference can result in dramatic tax savings.

To illustrate the potentially dramatic tax savings, let’s consider David and Donna Deferral, who developed an investment policy statement in Chapter 9. They are a married couple who are both 50 years old and who plan to retire at 60. David and Donna earn a combined $120,000 per year, and they file a joint income tax return. They claim the standard deduction and do not claim any dependents. The couple contributes a total of $30,000 to their retirement plans. They pay $10,200 in income taxes, $7,440 in FICA taxes, and $1,740 in Medicare taxes, which results in an after-tax net income of $70,620. David and Donna know that they will not receive a traditional pension and that they will be too young to qualify for Social Security when they retire, so they plan to withdraw money from their retirement accounts to fund their retirement.

David and Donna wisely deferred income taxes while they were working by taking income off the top of their preretirement income—income that would have been taxed at their marginal tax rate of 25 percent. Then, when they retire, they will withdraw $78,800 in the first year of their retirement from their tax-deductible retirement accounts. Those withdrawals will be spread across all of their postretirement tax brackets. The first $18,700 of retirement withdrawals will be taxed at 0 percent, the next $16,700 will be taxed at 10 percent, and the remaining $43,400 will be taxed at 15 percent, for a total income tax of $8,180 on the $78,800 withdrawn.

Since David and Donna will no longer have to pay Social Security or Medicare payroll taxes, they will pay $8,180 in tax and have the same $70,620 to spend after taxes. The result is an average or effective tax rate of only 10 percent on all of the withdrawals. They saved $19,700 in taxes on the first $78,800 they contributed but paid only $8,180 in taxes on the same amount withdrawn in the first year. As
Figure 10.1
illustrates, that’s a tax savings of $11,520!

David and Donna realized a dramatic tax savings in part because they dropped into a lower marginal tax bracket when they retired. It is likely that you will, too. There are a number of reasons you should be paying lower taxes in retirement. First, you will no longer have to pay Social Security or Medicare payroll taxes, which is an immediate savings of 7.85 percent, and double that if you are self employed. Also, you will no longer have to save a portion of your income for retirement. Assuming you save 10 percent of your gross income for retirement, the savings on retirement and taxes alone will reduce your required gross income in retirement by almost 18 percent. If you pay state income taxes, the savings may be even greater because your state may not tax retirement withdrawals as income, or because you may retire to a state that does not have state income tax. Other expenses may also be reduced or eliminated, such as work-related expenses, a mortgage payment, and college expenses for your children. Of course, if you receive less taxable income after you retire, you will owe less income tax as well. All totaled, you will probably be able to maintain the same standard of living after retirement with less gross income than before retirement.

You will probably drop into a lower marginal income tax bracket in retirement, and that will also save on taxes. It depends on how retirement withdrawals are spread across all income tax brackets. If your adjusted gross income (AGI) is pushed lower because of the way you are taking money out of your retirement accounts, that will result in a lower effective tax rate on the withdrawals.

Tax-deductible retirement accounts may provide even greater tax savings if the withdrawals are combined with tax-free retirement income. By replacing some of the withdrawals from tax-deductible retirement accounts with tax-free income, you can maintain the same level of spending in retirement while further increasing the tax savings and further reducing your income tax bill in retirement. For example, withdrawals from a Roth IRA are tax-free, and withdrawals of previous contributions to taxable investment accounts, including savings accounts, money market accounts, and certificates of deposit, are also tax-free because those funds have already been taxed. Money received from selling assets such as stocks, real estate, or mutual funds is also tax-free to the extent that you get back your original investment, while the gains are usually taxed at the long-term capital gains tax rate. Gains on the sale of your main home are also usually tax-free.

Assume David and Donna withdraw $10,000 from a money market account instead of their tax-deductible retirement account. They will reduce their income tax obligation by an additional $1,500, in which case they would pay a total income tax of just $5,512.50, for an effective income tax rate of only 9.17 percent! If they withdraw $20,000 from a money market account instead of their tax deductible accounts, they could reduce their income tax obligation by $3,000, for an effective income tax rate on the tax-deductible withdrawals of only 8.03 percent! Remember that David and Donna saved 25 percent in taxes on every dollar that they contributed to their tax-deductible retirement accounts while they were working.

Contributions to tax-deductible retirement accounts provide yet another tax benefit that other accounts do not—they reduce your AGI so that you may be able to qualify for certain tax credits or tax deductions. Examples include the child tax credit, the earned income credit, and the student loan interest deduction. Even if you already qualify for those or other tax credits or tax deductions, your tax-deductible retirement contributions may actually increase the amount of the tax credits or tax deductions to which you are entitled. Assume a married couple with at least one child files a joint return. They will receive the full $1,000 child tax credit so long as their AGI does not exceed $110,000. The credit is reduced by $50 for every $1,000 of AGI above that level. If the couple earned a combined $120,000 and contributed $10,000 to a tax-deductible retirement account, they will effectively increase the amount of the child tax credit by $500 and correspondingly reduce their tax bill by the same amount, in addition to the $2,500 they will save by deferring the income tax due on the tax deductible contributions.

Reducing your AGI provides another potential tax benefit: you may become eligible to contribute to a Roth IRA. A single person with an AGI of $121,500 can become eligible to contribute the full amount to a Roth IRA by contributing $16,500 to a 401(k) and thereby reducing the AGI to $105,000, the threshold at which a person is allowed to make a full Roth IRA contribution.

Contributions to a tax-deductible retirement account provide another tax benefit. You will retain the option of converting some of the tax-deductible contributions to a Roth IRA at lower marginal tax rates in the future, and you can time these conversions to get the best possible trade-off between paying current and future taxes. For example, assume you have sufficient savings to fund all of your retirement expenses in any given retirement year. You will probably not owe any income taxes at all, assuming no other sources of taxable income. The withdrawal of previously taxed funds from savings accounts or taxable accounts are completely tax-free. You will then have the option to convert some of the funds in your tax-deductible accounts to a Roth IRA without paying any income tax at all!

Consider David and Donna Deferral in the year they retire. If they sell their house for $300,000 and buy a smaller house for $200,000, they will have $100,000 to pay for living expenses—more than enough to fund their first year in retirement. With no other taxable income, they can then convert $35,400 from their rollover IRA into a Roth IRA. The first $18,700 is not taxed and will grow tax-free for the rest of their retirement. The next $16,700 is taxed at 10 percent, so they pay 10 percent tax now to avoid paying 15 percent tax later on the same money. They pay only $1,670 in tax and the rest of the money will cover part of next year’s living expenses.

If you will be in the fortunate position of receiving so much taxable income after retirement that you will be in the same marginal tax bracket after retirement, the tax savings just described would be eliminated. It is even possible that you could have so much taxable retirement income that you will be pushed into a higher marginal tax bracket in retirement as a result of tax deferrals. In that case, if you withdraw funds from a tax-deductible retirement account, you would actually owe more tax than if you had paid the income tax when you were working at the lower marginal tax rate.

Required distributions from IRA accounts start at age 70½. The distribution period for a 71-year-old is 26.5 years, and that means you will need to withdraw 3.6 percent of your IRA balance and pay income taxes on the distribution. The amount goes up over the years. When you are 81 years old, the distribution period is 17.9 years, and the distribution rate is 5.6 percent, which requires you to pay taxes on a larger amount. Here is the shocker: when you are 91 years old, the distribution period is 10.8 years. That means you must distribute 9.3 percent of your account balance and pay taxes on the entire amount. The older you get, the larger the required distribution and the more taxes you have to pay. Couple larger RMD distributions with the potential of higher income tax rates in the future, and retirees with substantial savings are going to be writing extremely large checks to the IRS in their later years.

Many people expect income tax rates to increase in the future to pay for the huge federal deficit we are accumulating. If marginal income tax brackets are indeed higher when you retire, the expected tax savings that you will realize from contributing to tax-deductible accounts may be reduced, but they’re unlikely to be eliminated because the progressive tax system is likely to be retained and expanded. The effective tax rate applicable to the withdrawals from your tax-deductible retirement accounts will probably be less than your marginal tax rate during your peak earning years, assuming higher income tax rates prevail after you retire. Recall that David and Donna saved 25 percent of every dollar that they contributed to their tax-deductible retirement accounts, but the effective tax rate on the withdrawals in retirement was only 10 percent, and even the last dollar was taxed at 15 percent. If the lower tax brackets are increased to 15 percent and 20 percent before they retire, they will still realize a net tax savings because they saved 25 percent of every dollar that they contributed while they were working.

If you are in a moderate or high marginal tax bracket, study the difference between tax-deductible investing and tax-free investing in a Roth IRA, or in a Roth 401(k) if your employer offers one. If you are in a high tax bracket, the tax savings from tax-deferred savings might be substantial. But if you are in a very low marginal tax bracket, you should prefer a Roth IRA over tax-deductible investing because the income tax that you would save now by investing in a tax-deductible retirement account is likely to be less than the tax you will pay when the funds are withdrawn in retirement. In addition, you may use a Roth IRA as a supplement to your retirement plan because your employer plan may have no choice or a poor choice in some asset classes, or you may need additional tax-advantaged investing space.

Roth IRAs offer a significant tax benefit. Anyone who qualifies to contribute to a Roth IRA should consider including this vehicle as part of a well-rounded retirement savings plan. The tax benefits of a Roth IRA are the mirror image of the tax benefits of tax-deductible retirement accounts. Contributions to a Roth IRA are not tax-deductible, and they do not reduce your AGI, but withdrawals in retirement are tax-free.

The tax-free Roth account offers a form of protection against future income tax rate increases in retirement. Retirement income from Roth IRAs reduces the amount of Social Security benefits that are subject to income tax, because the income is not included in your AGI that is used to calculate how much of your Social Security benefits are subject to income tax. Of course, there is also a small risk that Congress will change the rules and make Roth IRA withdrawals partially taxable, or limit the amount of tax-free withdrawals by some form of means testing, with high earners paying more in taxes per dollar withdrawn.