Planning for your retirement can be a somewhat complicated process. You need to crunch a lot of numbers and try to estimate how much money you will spend. One of the factors that makes it even harder for many people to plan is taxes.
The good news is that in many cases, you may actually be overestimating your taxes during retirement. Explore some of the reasons that you are likely to pay less in taxes than you think and why this matters.
Why Should You Try to Accurately Estimate Your Taxes?
To put it simply, being able to accurately estimate your taxes helps you make informed decisions regarding your retirement.
To start, you will need to factor in your tax rate when estimating how much money you need to save. Specifically, your after-tax retirement income becomes the big factor here.
The other important situation where tax knowledge can influence your decision is whether you should make pre-tax contributions or Roth contributions. This is especially important, as more people use Roth 403(b) and 401(k) plans.
You May Overestimate Your Income, Changing Your Tax Bracket
Remember that the US tax system uses tax brackets. Your income during retirement will likely be lower than it is while you work. For many people, this makes a big enough difference to drop you to a lower tax bracket.
That can be especially true if you will have lower expenses during retirement. For example, if you know that you won’t have to be financially responsible for your kids anymore, will have less debt, or will live in a lower cost of living area, you may need less retirement income.
While the typical estimate is that your retirement income should be about 70% to 80% less than pre-retirement, that doesn’t account for all the above factors. If you downsize and have significantly fewer expenses, you may need less than this.
The result can be a drop to a lower tax bracket and a correspondingly lower tax rate.
You May Have a Lower Effective Tax Rate
Even if you stay in the same tax bracket during retirement, you may find yourself with a lower effective tax rate.
This connects to the way tax brackets work and the fact that you will be making less during retirement. Remember that as you move up to another tax bracket, only your income within that bracket’s range is taxed at the higher rate.
In other words, $9,950 of your taxable income would be in the first tax bracket, so you’d pay 10% taxes on that. The next bracket goes up to $40,525 and is 12%. But the higher tax rate only applies to the income above the $9,950 (So $40,525 – $9,950 is taxed at 12%). Repeat this process as you move up the tax brackets.
The key here is that you will have less income taxed within the highest tax bracket that you are eligible for than you would pre-retirement. After all, you make less. This means that when you calculate your effective tax rate, it will be a lot lower than the rate for your tax bracket.
This also applies pre-retirement, which is how someone making $50k could be in the marginal tax bracket of 22% but have an effective tax rate of just 13.5%.
On top of that, remember that some of your retirement income won’t even be taxed thanks to exemptions and deductions.
You May Overestimate How Much of Your Income Is Taxable
You’ve been working for your whole life, so you are used to most of your income being taxable. After all, it typically comes right from your job. So, you just account for exemptions and deductions, then are taxed at the standard rate.
But your retirement income is different. While some of your retirement income is fully taxable, not all of it is.
If you have wage income, business income, or rental income in retirement, that will still have the regular income tax rates. That will also apply to your pension income and any withdrawals from your taxable retirement accounts.
But a big part of your retirement income will likely come from your Roth retirement account. As long as you are at least 59 ½ years old and have had your account for five years or more, withdrawals from that account are tax-free.
On top of that, you can access the principal from investments and savings without paying taxes. When you have long-term capital gains, they will have lower tax rates during retirement. If they are long-term losses instead of gains, they can actually lower your other taxes.
On top of that, your social security income is taxed slightly differently. You only pay taxes on part of it. But you pay ordinary income tax rates on that portion. Figuring out how much in taxes you will pay on Social Security usually requires a financial planner or a sophisticated financial planning application such as WealthTrace or eMoney. These types of financial planning packages can project out how much you will pay in taxes based on the income source by year.
You May Move to a Tax-Friendly State
There is also the fact that you won’t necessarily retire in the state that you currently live in. Many retirees choose to move to tax-friendly states with low or no income taxes. For example, Nevada, Florida, and Texas don’t charge state income taxes.
A Quick Summary
So, before you start planning for your retirement needs, make sure you have a full grasp on your taxes. Remember to look at your effective tax rate instead of your marginal tax rate and be realistic about your retirement income. Don’t forget to consider if you’ll move somewhere with lower taxes. If you ever feel overwhelmed by the various calculations, take advantage of online financial planning and retirement calculators or consult an expert.