The notion that lower taxes in retirement is a given is often touted by the financial industry. However, this idea can be misleading and potentially detrimental to one's long-term financial health. The following reasons illustrate why the expectation of significantly lower taxes in retirement may not hold true.
1. Rising Tax Rates
One primary factor that challenges the notion of lower taxes in retirement is the potential for rising tax rates. Governments around the world are grappling with increasing debt levels and aging populations, which could lead to higher taxes in the future. While current tax rates might seem favorable, they are subject to change. If tax rates increase, retirees may find themselves paying more in taxes than they anticipated, eroding their retirement savings faster than expected.
2. Loss of Deductions and Credits
Many individuals benefit from various tax deductions and credits during their working years. Mortgage interest, child tax credits, and contributions to retirement accounts like 401(k)s and IRAs can significantly reduce taxable income. However, once retired, many of these deductions and credits disappear. Without the ability to offset income with these tax benefits, retirees could face a higher effective tax rate on their income.
3. Income Sources in Retirement
The composition of income changes in retirement, often leading to unexpected tax consequences. While wages from employment are replaced by Social Security benefits, pension payments, and withdrawals from retirement accounts, these sources of income can be taxable. For example, up to 85% of Social Security benefits can be taxable if combined income exceeds certain thresholds. Additionally, traditional 401(k) and IRA withdrawals are taxed as ordinary income, potentially pushing retirees into higher tax brackets.
4. Required Minimum Distributions (RMDs)
Starting at age 72, retirees must begin taking required minimum distributions (RMDs) from their traditional retirement accounts. These RMDs are calculated based on the account balance and the retiree’s life expectancy and can result in substantial taxable income. Failure to take RMDs results in a hefty penalty, further emphasizing the tax burden these distributions impose. The mandatory nature of RMDs means retirees have limited control over the timing and amount of their taxable income.
5. Healthcare Costs
Healthcare expenses tend to increase with age, and many of these costs are not fully covered by Medicare. Premiums for Medicare Part B and Part D, as well as supplemental insurance and out-of-pocket expenses, can be considerable. While some medical expenses are tax-deductible, they must exceed a high threshold relative to adjusted gross income. Thus, the tax relief provided by these deductions is often minimal compared to the overall cost burden.
The assumption that taxes will be lower in retirement is not a guaranteed reality. Without careful planning, retirees may find themselves facing a tax landscape far different from the lower-tax scenario they once envisioned. It is in your best interest to work with a fiduciary financial advisor to help navigate the complexities of retirement income.
Financial Enhancement Group is an SEC Registered Investment Advisor.
