One of the most common mistakes I see people make is overestimating their tax rate in retirement. This is important for several reasons. First, as the Roth 401 (k) and 403 (b) plans become more common, estimating your future tax rate is an important factor in deciding whether to make Roth or pre-tax contributions. Second, your tax rate is used to estimate your after-tax retirement income to determine how much you need to save. Let’s take a look at some of the reasons your retirement tax rate will likely be lower than you think:
All your retirement income is tax-free
When you work, most of your income comes from your work and is fully taxable (after deductions and exemptions) at regular tax rates. When you are retired, this is only true for pension income, withdrawals from taxable retirement accounts, and any rental, business and salary income you have. Social security is tax at ordinary income rates, but only a portion is taxable. Withdrawals from Roth accounts are tax free if you have had the account for at least 5 years and are over 59 1/2 years old. Access to savings and investment capital is tax-free, and long-term capital gains are taxed at lower rates or may even reduce other taxes if you sell at a loss.
Your income will likely be lower
Experts generally estimate that you need around 70-80% of your pre-retirement income in retirement, but you may have even less depending on your situation. How much of your income is spent on retirement savings and paying for social security? Do you have a mortgage and other debts that will be paid off? Do you have children who will no longer be financially dependent on you? Are you considering downsizing or moving to a lower cost area?
When you add all that up, you might find that you need less than 80%. If your income is reduced enough, you can 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 contribute to a retirement account, you probably want to look at your marginal tax rate. This is the tax rate you pay on an additional dollar of income. The reason is that the next dollar you contribute to your retirement account would normally be taxed at the marginal tax rate.
Let’s say I’m a single person with taxable income of $ 50,000 per year. That puts me in the 22% marginal tax bracket for 2021. But according to this calculator, my effective tax rate would be 13.5% of my taxable income since only my taxable income over $ 40,525, or $ 9,475, would be taxed at this 22% rate. The rest would be taxed at 12% or less. However, if I contribute $ 7,000 to my 401 (k) before tax, all of that $ 7,000 would normally be taxed at the rate of 22%.
Now what happens when I withdraw money from my 401 (k) at retirement? First, part of my income will not be taxed at all because of the deductions and exemptions. In fact, my standard deduction would be $ 1,700 higher if I was 65 or older this year.
The first $ 9,950 of taxable income would only be taxed at 10%. Then the next group of income up to $ 40,525 would be taxed at 12%. Only income over $ 40,525 would be taxed at the 22% rate. Unless I retire with a large pension (which is rare these days), a large chunk of those 401 (k) contributions will likely be taxed at the lower rates.
You also want to use this lower effective rate when estimating how much of your retirement income will be used to pay taxes. Unfortunately, too many financial plans use the higher marginal rate. While this is a more conservative assumption that might motivate you to save more, it might also discourage someone from thinking that they might one day retire.
For example, a couple I spoke with did not think they had enough income to retire. However, they assumed that 22% of their income would go to taxes because their retirement income put them in the 22% tax bracket. But when I estimated their retirement tax bill, it was only about 4% of their income since Social Security was such a large percentage of their income and only half was taxable at all. (See the first point.) Those 20 percentage points made a huge difference for them.
You can retire in a less taxed state
Many states are very tax-efficient for retirees, while some popular retirement destinations like Texas, Florida, and Nevada don’t even tax income at all. You can use This site if you’re curious about how much you can save when you retire in a low-tax state. When you do the math, you’ll see that hot weather isn’t the only thing some states have going for them.
For all of these reasons, you may be overestimating your taxes in retirement and therefore underestimating your net retirement income. Fears of a tax hike could also point you towards Roth rather than pre-tax pension contributions. It might be a good idea to scare yourself off into saving more or making Roth contributions, but higher taxes in retirement aren’t necessarily the best reason to do so.