Myth Busters - Lower Taxes in Retirement
The myth of lower taxes in retirement
Tax planning is no longer just something we do at the end of the year. Long term tax planning should be thought of in 5 year increments. While retirement may seem a ways off for some of you, a major part of future tax planning is a tax efficient retirement.
As a successful dentist, you would assume that your income during your years of practice will be much higher than your retirement income. You don’t imagine paying more in taxes because you are no longer earning money; rather, you’re now living off what you’ve accumulated over a lifetime. With your income being lower than it was during your working years, the amount you will owe to the IRS will be less, right?
Not necessarily. For a short time after you retire, you may be in a lower tax bracket. That window can shut quickly, once required minimum distributions (RMDs) kick in at age 72, in combination with income from investments, SS Benefits and rental income from your practice building, you will quickly move into a tax bracket equivalent to your working years.
In retirement, you will have multiple streams of income coming from various sources, most of which are being taxed at different rates. Without proactive income, investment and tax planning, you can get caught up in a complex system of multiple calculations.
Pay me now or Pay me later
It can very tempting to accumulate your retirement funds in pre-tax retirement accounts. Pre-tax is the operative word here. Your money—both the contributions and the growth—has never been taxed, and the IRS has been waiting for their share for decades!
The alternative is to accumulate at least a portion of your retirement funds in post-tax (or ROTH) retirement accounts. The ROTH contribution is taxed at your current tax rate but upon distribution, you will not pay tax on the original contribution AND the growth. The ROTH option can be incredibly effective for our younger clients as you have a longer growth window. Regardless of the retirement vehicle (401k, IRA or SIMPLE plan) the ROTH option is available.
The tax rate affect
One other large piece to the puzzle we have to consider is the tax rate.
The current tax law is in effect until the end of 2025, at which point it will sunset, which means on January 1, 2026, taxes will go up to the rates in effect prior to TCJA. Across most brackets, the difference between the current rates and the future rates on January 1, 2026 is between 9.7% and upwards of 25%. In other words, there is an opportunity right now through proactive tax planning to reduce your taxes between 9.7% and 25%.
However, the tax landscape is likely to change due to COVID-19 and the potential change in leadership after November’s election. The United States has accumulated a staggering amount of national debt ($22.8 trillion at 12/31/19). With the current pandemic and the massive stimulus bills to keep the economy from collapse, the debt level is projected to be as high as $28 trillion by the end of the year.
At some point, our country must pay for that debt. The federal government has multiple tools, including selling Treasury bonds, for paying our debt down. Unfortunately, the most reliable way is raising taxes and you can see that significantly higher taxes in the years ahead are highly likely.
As an historical context, in 1944 and 1945, the top marginal rate was a staggering 94%. It was 91% from 1954 to 1963, and it didn’t drop below 70% until 1981. Marginal rates in the 30th percentile is a fairly recent development. As much as we want to, we can’t dismiss the possibility that taxes will reach those heights in the future.
Now is the time to proactively plan for avoiding those higher taxes in retirement and ensure that you give less of your hard-earned money to the IRS.