If you’re like me, paying taxes each year is something I am willing to do, but I certainly do not want to pay more than required. This desire to pay fewer taxes however, can lead to trouble if you are not careful.
While most of the professional commentary encourages tax deferred treatment for as many of your retirement assets as possible, this may not be the best direction. Today, for those still working, their retirement lives may be as long as their working lives. And over such long periods of time, you can bet your retirement the treatment of taxes will change and most likely more than once.
For some professions, it is not impossible to save $10,000 per year. If you were able to do this for forty years and average a 9 percent annual return, the value at retirement would be over $3.3 million. If you were to save all of these dollars in tax deferred plans such as Individual Retirement Accounts, Simplified Employee Pension Plans, or savings plans such as the 401-k, you will have substantial assets available at retirement. While this will provide a wonderful retirement for most, it will also create an annual tax headache.
In my example, if the retiree followed the typical direction, most likely the entire retirement account would be tax deferred. Thus, their entire retirement income would be subject to income taxes when received. The reason for this action in the past has been we expect our retirement income to be less than in the years we were working and to be taxed at lower rates. This is another old adage that may no longer have the same truth it had years ago.
Today, there are six brackets with tax rates from 10 percent to the top rate for couples of 35 percent. While taxable income of $63,700 will be taxed at a marginal rate of 25 percent, the couple can earn an additional $286,000 of taxable income before they reach the top tax bracket just ten percentage points higher. In the mid seventies, the highest marginal tax rate for couples was 70 percent, twice the rate of today. In the early eighties, the highest marginal tax rate was 50 percent on income as low as $109,400. Clearly, Americans today are paying some of the lowest income tax rates they have paid in decades.
A review of the U.S. income tax rates from 1913 to current shows the rates have been anything but steady. The marginal rate has also ranged from very low to high on more than one occasion. Thus, it is possible for retirees and those retiring in the next decade or so to see the U.S. income tax rate climb once again. If this becomes true, your retirement dollars may actually be taxed at higher rates than when you were working and had higher taxable income. Thus, this would be in direct conflict of the presumption your retirement income will be less than your working income and taxed at lower rates.
In my earlier example of a worker saving all of their retirement dollars in tax deferred accounts, this individual would have very little control over their taxable income. All of their retirement dollars would be subject to income tax once withdrawn for use. Most likely, the amount they withdraw from their retirement accounts will cause 85 percent of their normally tax-free Social Security income to be subject to income taxes. If they are fortunate to have a pension, the monthly check would also be subject to taxation.
Having options during retirement may be important in the event tax rates increase along with the number of brackets. It will be crucial to have assets that could be taxed at different rates or sources that will provide income without increasing the taxable income. The only way this can be achieved would be to divert a portion of the contributions originally going into tax deferred accounts into other options. These options would include direct purchases in investment real estate, purchases of REITs, taxable brokerage accounts, investing in Roth IRAs or Roth 401-ks, building value in traditional or variable life insurance plans, as well as other options. While the management of your investment assets may have increased, the ability to manage the impact of income taxes has improved dramatically. Instead of having only one source of income, there would now be accounts that could provide additional income without increasing your taxes or could be taxed at rates other than ordinary income rates, such as capital gains or dividend rates. Having these options will permit you to manage your income flow and thus the taxes you would have to pay. Options are powerful; and, if the income tax rates once again climb, you will want every option available.
If you have questions on this topic or others, please contact my office or another financial professional in our area.
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Would you like a response to a financial question? Send your question to Doug Horn, 115 W. Broadway, Maryville, TN 37801. Be sure to mark your envelope Money Matters.
Doug Horn, CFP, is an area financial planner with more than 24 years financial experience and founder of Quality Financial Concepts, located in downtown Maryville on Broadway.
Doug Horn, CFP, Registered Investment Advisor in Tennessee and Texas and Registered Principal, Branch Office of and Securities offered through CUE Financial, Member FINRA, SIPC.