Many people anticipate that their largest financial burden will be healthcare expenses in retirement. However, they may be taken aback to discover that, in numerous cases, the foremost financial concern is income taxes. Those who fail to prepare for the impact of the IRS on their retirement finances are vulnerable to a substantial tax hit that could have been avoided.
Furthermore, this issue is poised to escalate over time. It is essential to examine federal spending and the ever-expanding interest on the national debt to comprehend why income taxes may become an even more pressing issue for future retirees compared to current ones. A recent report by the Congressional Budget Office (CBO) predicts that net interest on federal debt is expected to reach $10.5 trillion by the end of the decade.
At some point, this debt will need to be repaid, and that responsibility will fall on the shoulders of American taxpayers. It is a significant problem that has persisted for quite some time. As far back as 2011, David Walker, former Comptroller General of the United States and head of the Government Accountability Office, warned in a CNN interview that any additional debt accumulation would essentially lead to deferred tax increases unless there were substantial reductions in the size and role of government.
Around 2008, then-U.S. Rep. Paul Ryan of Wisconsin asked the CBO to assess the impact of raising marginal tax rates to fund future spending on Medicaid, Medicare, and Social Security. The CBO estimated that tax rates across all brackets would need to more than double. In other words, tax rates would increase significantly at every level.
This is not a favorable scenario for most retirees, who would struggle to accommodate such tax hikes in their annual budgets.
The taxes you pay in retirement are primarily determined by your taxable income, which brings us to the other part of the problem. In retirement, most income sources, including Social Security, pensions, and retirement savings withdrawals (e.g., traditional IRA or 401(k)), are subject to taxation as ordinary income. While some may be surprised that Social Security can be taxed, up to 85% may be subject to taxation if your combined taxable income exceeds certain thresholds.
Individuals qualify for Medicare at age 65, another retirement consideration. While it is not free, with premiums often deducted from Social Security payments, an extra surcharge can apply when your taxable income surpasses a specific threshold, substantially increasing your Medicare costs.
So, what can be done to address this issue? Here are a few recommendations:
#1 Shift funds to a nontaxable account:
If you have an IRA or 401(k), consider transferring some or all of the money into a Roth account. While you’ll pay taxes during the transfer, your money will grow tax-free, and you won’t pay taxes on withdrawals in retirement. Gradually transferring funds can help you avoid jumping into a higher tax bracket.
#2 Recognize there are no limits on Roth conversions:
The conversion of money from a traditional account to a Roth account is not restricted, unlike Roth contributions, which have annual limits. Consider maximizing your tax bracket without moving into a higher one when doing a Roth conversion.
#3 Consider investments with favorable tax treatment:
Diversify your investments to include assets that receive capital gains tax treatment, often resulting in lower taxes than ordinary income. Capital gains tax has fewer brackets, including a zero-tax bracket, making it a tax-efficient choice.
As you approach retirement, it’s crucial to make informed decisions and address these tax-related issues to structure your income to minimize your tax liability. This approach will ultimately lead to more funds for your retirement, and your heirs, and less revenue for the government.