Are Taxes Higher or Lower in Retirement?

One of the more common mistakes we see people make is overestimating the taxes they’ll have to pay in retirement. They look at their portfolio, which might consist of mostly pre-tax assets like their 401(k) or traditional IRAs, and their personal money, where they may own stocks or funds with a lot of capital gains after the long bull market we’ve seen. Some also have homes they’ve owned for many years, with quite a bit of equity built up, that they plan on selling once they’ve retired in order to either downsize or move closer to other family members.

So they add all of that up and figure that once they start selling those assets in retirement, they’ll be stuck with a lot of taxes to pay—both on ordinary income and capital gains.

But in many (if not most) cases, this just isn’t true. More often than not, people see a lower tax bill in retirement than they thought they would.

So why are taxes often lower in retirement than during your working years? There are several reasons. 

First, many people have really diverse sources of retirement income, with different tax treatments on each. You might have a pension, some pre-tax retirement plan distributions, Social Security benefits, some Roth distributions, and other sources of income. Some of these will be fully taxable, others will be partially taxable, and still others won’t be taxed at all. When you blend these together, it’s impossible to come up with a tax rate that’s higher than the marginal ordinary income rate you’d have to pay on a comparable amount of salary from work.

Another reason taxes are often lower in retirement is that retirees don’t need to earn nearly as much in retirement in order to enjoy the same—or a better—lifestyle. You won’t be putting money into your 401(k) anymore, and you won’t have FICA and Medicare taxes to pay. So right off the bat, your income need could be 15–20% less than your current gross salary. Maybe your mortgage is paid off at that point and the kids are on their own. So when you add all this up, it only stands to reason that if you’re earning less, your tax bill will be lower.

Of course, there are always exceptions to this. People with very high pension benefits and those with multiple millions in their retirement accounts will probably be in as high of a tax bracket—or higher. And there are instances where a large capital gain, RMD, or some other taxable event could cause bracket creep in retirement. But that’s more the exception than the rule.

The key is to begin building tax diversification before you retire. That’s something we at Lucia Capital Group call tax alpha—seeking to add value by potentially increasing net after-tax returns. Because sometimes it’s not just what you earn that matters—it’s what you keep.

 

Important Information:

The information provided should not be considered specific tax, legal, or investment advice and is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. This material was gathered from sources believed to be reliable, however, its accuracy cannot be guaranteed.

These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.

No client or prospective client should assume that the presentation (or any component thereof) serves as the receipt of, or a substitute for, personalized advice from Lucia Capital Group or from any other investment professional.

IRA withdrawals will be taxed at ordinary income rates. Withdrawals prior to age 59½ may also be subject to a 10% penalty tax.

Roth IRA distributions of principal from a Roth IRA are tax-free; however, any earnings will be taxed at ordinary income rates and a 10% penalty tax will apply if withdrawn prior to age 59½ or within five years of the date the Roth IRA was established, whichever is longer.

The information provided is based on current laws, which are subject to change at any time. Lucia Capital Group is not affiliated with or endorsed by the Social Security Administration or any government agency.

Social Security rules can be complex. For more information about Social Security benefits, visit the SSA website at www.ssa.gov, or call (800) 772-1213 to speak with an SSA representative.

Rick Plum is a registered representative of, and offers securities through, Lucia Securities, LLC, a registered broker/dealer, member FINRA/SIPC. Advisory services offered through Lucia Capital Group, a registered investment advisor, and an affiliate of Lucia Securities, LLC. Registration with the SEC does not imply a certain level of skill or training.

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