Are you worried about taxes in retirement? 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 your other taxes if you're selling at a loss. (Gains on inherited investments are only taxed from the point that you inherited them.)
But what if all of your retirement income is fully taxable?
Your Income Will Probably Be Lower
Experts typically recommend that you need about 80% of your pre-retirement income in retirement. But depending on your situation, you may need even less. 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? How much do you spend on commuting and other work-related expenses? Will you eat lunch out less often since you're no longer at work during the day and have more time to prepare your own meals? 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 25% marginal tax bracket. But according to this calculator, my effective tax rate would be less than 17% since only my taxable income over $36,900 or $13,100 would be taxed at that 25% rate. The rest would be taxed at 15% or less. However, if I contribute $7k to my 401(k) pre-tax, all of that $7k would normally be taxed at the 25% 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 $1,550 higher if I was age 65 or older this year.
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