Losing The Conventional Wisdom Part 1:
We're NOT Going To Be In A Lower Tax Bracket In Retirement
Among the more pernicious myths of the 20th century is the notion that it’s good to defer taxes because, in retirement, we’ll all be in a lower tax bracket. This is treated as gospel by CPAs and mere mortals alike. We believe that, when the piper demands his due, we’ll be enjoying our financial freedom—retirement—at a discount.
It looks like I must be the one to break it to you: Unless you are going to sell everything, stay in hostels when you travel, and otherwise live like the starving young professional you haven’t been in 30+ years, you’ll be in the same tax bracket when you retire as you are today. Arguably, since taxes have dropped considerably over the last half century, there’s even the possibility you’ll be in a higher tax bracket by the time you retire. Even if you really do need less and spend less in retirement, the tax code doesn’t support this idea.
Prior to 1995, federal tax brackets for married couples filing jointly were 15%, 28%, 31%, 36%, and 39.6%. Thus, retirees who did alter their lifestyles dramatically would see a dramatic drop in taxes. But a 20% drop in required income would not drop anyone into the next lower bracket. If my household was earning $200,000 in 1995, I’d be in the 36% bracket. If I was earning $160,000, I’d still be in the 36% bracket. Therefore, I’d need to reduce my lifestyle by more than 50% to drop into the 31% tax bracket.
Please remind me why I’d want to do that after working my tushy off my entire career.
I know that few households earned $200,000 in 1995. But even if a household earned half that, it would still take an income reduction of more than 60% to drop from the 31% to the 28% bracket. So, not only is the notion of being in a lower tax bracket a myth in the 21st century, but it was likely a myth in the 20th century as well.
Today, a household that earns $200,000 (and up to $383,900) is in the 24% tax bracket. That means a household would need to reduce their income needs in retirement by more than half to get to the 22% tax bracket. I ask: How many of you really intend to alter your lifestyle that much in retirement? I, for one, want my travel to get bigger, not smaller. I expected to trade a house for a condo. But it’s not going to cost any less. And I want to increase my gifts to children and grandchildren, not reduce them.
And that brings me to the annual grudge match my clients and I have had with our trusted tax professionals, the CPAs. First, my dear tax accountants, I appreciate you. I appreciate you because I find your work so annoying, that I’m forever grateful to outsource it to you. And I totally get that your clients reward you with smiles and kudos when you save them money in the current filing year. But there is no way that saving the tax on $30,500 (max 401(k) plus catch-up) of income x 2 spouses = $61,000 x 24% = $14,640 is worse than paying the tax out of savings on $244,000 when it has doubled twice in 20 years (for the record, that’s $58,560 in taxes) because you will be in the same tax bracket.
We are so caught up in our tax code and the few deductions a W2 employee can take that we forget to do the math for when it counts down the line.
Even solopreneurs, partners, and contractors should understand that saving for retirement pre-tax is rarely the benefit it’s made out to be. And I want to double down on how awful it feels to pay taxes out of savings rather than cashflow.
Imagine your portfolio has finally made it to $1,000,000, and you discover that only $760,000 of it is actually yours.
Go ahead, I’ll wait.
With all that said, let’s figure out how to optimize taxes in retirement. It means paying taxes today to have tax-free growth in vehicles like: Roth 401(k)s and Roth IRAs (and the new Roth SEP IRA and Roth Employer Contributions); and whole life policies. (Yes, whole life is a tool for tax-deferred growth.) If you’re legacy-minded, Roth dollars and whole life death benefits are inherited tax free. And that’s certainly a gift to your children, who are likely to inherit your wealth during their highest earning years.
After a career of pre-tax saving, we might spend some years after age 50 finding an amount we can “live with”—say $25,000 to $50,000, annually—and convert it to Roth, sucking up the taxes we are willing to pay. By the way, it’s not your fault that you didn’t know this before. It is only since 2010 that tax filers in higher-income ranges are permitted to do Roth conversions. I jumped on it myself in that tax year. And my accountant was (ahem) not pleased. Nor was he pleased when I contributed to my 401(k) on a Roth basis. Eventually, he stopped being my accountant.
I know that for a lot of us, Roth IRA savings did not exist early in our careers. But they exist now. And there’s no age limit to how long you can contribute income to them that grows tax-free. Even if you are technically retired, if you have $8,000 of part-time “pays for my mani/pedi” income in 2024, go ahead and stuff $8,000 from your other pocket into a Roth IRA. Your wise older self will thank you.
And please tell your kids to pay the tax on the seed and not on the crop because no matter what they hear or read, they will certainly not be in a lower tax bracket down the road.
Happy tax season to my CPA friends. We’ll see you again when you come up for air at the end of April!
#MoreRunwayThanYouThink #WeRescueOurselves
© 2024 Madrina Molly
