Too Many People Rely on this Faulty Tax Planning Assumption
A great many of my clients come to me with all their retirement savings in tax-deferred accounts. They have spent years following the advice of so-called “gurus” who say things like, “It’s ok to have all your retirement savings in the tax-deferred bucket because, when you retire, you’ll be in a much lower income tax bracket than you were during your working years.”
Today, I’d like to put this claim under the microscope – and explain why this is a faulty assumption for several reasons.
Underfunded Government Liabilities
The Baby Boomer generation is celebrated for many reasons, but they are also a “demographic glitch” that is having a significant impact on the solvency of Social Security. At the inception of this entitlement program, there were 42 workers contributing to Social Security for every one person who was taking money out. Because of the vast size of the Baby Boomer generation, however, the workers-to-retiree ratio has continued to drop over time, jeopardizing the solvency of Social Security and other entitlement programs. Today, the ratio has fallen from 42 to 1 to an unsustainable 3 to 1. In another 10 years, it’s going to be closer to 2 to 1. This makes Social Security a huge, underfunded liability that the federal government is going to have to pay for somehow. And since income tax rates have been at historically low levels over the past 20+ years, it stands to reason that a tax hike is in our near future.
Even if you believe the far-fetched assumption that future tax rates will remain the same as they are today, you must contend with a second concern about your tax-deferred accounts.
When you retire, all the tax deductions you experienced during your working years literally vanish into thin air – right when you need them the most.
Let’s take a look at the top four deductions during a typical American’s working years:
This is far and away the number one source of deductions for those who itemize. Every year, you can deduct interest on up to $750,000 of debt on your residence. But here’s the problem: Most of the retirees I see week-in and week-out already have their homes paid off. So, the biggest source of deductions is nonexistent for many retired Americans.
This is a significant source of savings because your children count as a tax credit. A credit is far more valuable than just a deduction. A deduction is a dollar-for-dollar reduction in your taxable income, but a credit is a dollar-for-dollar reduction in your tax bill! The American Rescue Plan, signed into law on March 11, 2021, expanded the Child Tax Credit for 2021. It went from $2,000 per child in 2020 to $3,600 for each child under age 6. For each child ages 6 to 16, it has increased from $2,000 to $3,000. Are your children still living with you in retirement? You hope not, right? But even if they are, they’re likely well past the age when they can be counted as dependents.
Retirement Plan Contributions
Are you still contributing to your 401(k) or IRA in retirement? Of course not! The whole reason you had these accounts was so that you could take money out in retirement, not continue to make contributions for the purpose of tax deductions.
Once charitable, always charitable. Most retirees who made gifts to their favorite causes while working will continue to give back in retirement, too. The difference is that, during retirement, there’s less money to go around. So instead of donating money, many people donate time. In lieu of making that check out to the soup kitchen, they might actually go down to the soup kitchen and ladle the soup themselves. And while this is incredibly noble and worthwhile, it simply doesn’t show up on the IRS’s radar as a deductible activity.
All of these deductions during your working years might have added up to $50,000, $60,000, or in some cases $70,000. But absent any of these deductions in retirement, what’s left? The IRS gives you a choice. You can add up all the above-mentioned deductions (and other miscellaneous ones) and use that total to offset your taxable income. This is known as itemizing. Or you can take the standard deduction which, in 2021, is $25,100 for joint filers. Because many of the itemized deductions phase-out before retirement, most retirees are stuck with the standard deduction.
So, if you need $120,000 per year of income in retirement and your deductions are only $25,100, then your taxable income would be $94,900 per year. That puts you at a marginal federal tax rate of 22%. Throw in another 6% (on average) for state tax, and you’re looking at a marginal tax rate of 28%. That’s a lot higher than most retirees are anticipating!
In his book The Power of Zero, David McKnight– a renowned industry leader in tax-free retirement planning, and my personal mentor – shares an exchange he once heard on a financial radio show that went something like this:
Caller: I don’t understand. I have less income in retirement than I did during my working years, yet I’m paying more in taxes. How is that possible?
Host: Tell me about your deductions.
Caller: Deductions? I ran out of those a long time ago.
Host: I see. I think I know your problem . . .
You see, it all comes down to deductions. Even if tax rates in the future are the same as they are today, you could still end up in a higher-income tax bracket in retirement than in your working years.
What Do You Truly Believe About Future Tax Rates?
Deciding whether to contribute to tax-deferred accounts really comes down to what you think about the future of tax rates. If you think that your tax rates in the future are going to be lower than they are today, you should put as much money as you possibly can into tax-deferred investments. Get the tax deduction at today’s higher rates and pay taxes at a lower rate down the road.
If, conversely, you believe that tax rates in the future will be higher, even by 1%, then mathematically you are better off limiting your contributions to tax-deferred accounts.
If you’re interested in learning more about how you can lower your tax bracket or reach zero tax liability in retirement, let’s start a conversation. Call to schedule a strategy session and take the first step toward a more financially secure retirement.