Rethinking Taxes From a “Tax Risk” Perspective
When you think about building a financial plan that will help you meet your goals at every stage of your financial journey, from your early working years through retirement, saving, and investing are usually the first things that come to mind.
Starting early, saving as much as possible, and being thoughtful about how you allocate your investment portfolio to balance risk and return potential are the basics for most investors. As you continue to increase your income and your investments grow through the power of compounding, taxes become a more critical component of your long-term savings and investment plan.
Consider Tax Planning Today to Maximize Income in The Future
There is a good basis for an argument that taxes should always be considered alongside investing. After all, they are both at the core of maximizing future income. Investing can help you grow your future income, and tax planning can help you keep more of the growth you’ve achieved.
Surprisingly, as you transition into retirement, there is a lot to manage with your taxes now that you are not working and earning an income from employment (or having taxes withheld on a regular basis from those earnings). To have the retirement income you want, you must engage in proper tax planning throughout your working years to complement your investing strategy. Taking a comprehensive approach to tax planning that borrows from a key investing concept can yield meaningful results. Thinking about your taxes in terms of tax diversification (or tax allocation) and building that into your retirement plan can help your plan stay on track and minimize the impact of surprises in the future. You can achieve tax diversification by placing your savings dollars into the right type of account based on its tax treatment to minimize tax risk and help ensure a sustainable level of income (and taxes) in the future.
Updating Outdated Retirement Tax Assumptions
It used to be assumed that because you are not earning an income in retirement and are living on your investments (and possibly Social Security), your taxes will be lower than they were in your working years. Commonly, it was believed that you only need about 70% of your working income to sustain an enjoyable retirement lifestyle. In the two-plus decades we have been assisting individuals with their transition into retirement, we have found this assumption to be false. You should plan to have 100% of your current net income today in retirement. Some of your current expenditures will indeed go away, but you will likely find something else to spend those dollars on in the future.
While you are still employed, remember that you do not have to pay any income taxes on the health insurance premiums, and many employers offer HSA and FSA plans that allow you to take care of out-of-pocket health expenses on a tax-free basis. When you retire, you will no longer get a tax deduction for your medical insurance premiums or out-of-pocket medical expenses. These are typically the biggest expenses for retirees in the US! If you spend more than 7.5% of your total retirement income on these things, you may be eligible to itemize your deductions. It is not a $ for $ reduction to your taxable income like when you are still working, and with the introduction of a higher standard deduction, less than 15% of all US taxpayers itemize their deductions. (Statistics from the IRS based on 2019 tax returns filed.)
Lastly, there is also the reality that income taxes may increase in the future regardless of whether your income changes. This is called tax legislation risk. The current income tax brackets represent the lowest effective tax rates (based on the brackets) since the early 1900s. It is important to understand that this will change at some point in the future. It can encompass everything from existing tax cuts expiring to tax loopholes closing and changes to individual income tax brackets. This is an ongoing reality and something that needs to be planned for in a solid retirement income plan to ensure that pitfalls are avoided and that opportunities – which often have brief time frames for implementation – are taken advantage of.
Minimizing Tax Risk Through Diversification
Tax risk considers how much you are taxed when taking distributions from your investments. Managing tax risk is all about how much of a bite taxes will take out of your investments when you’re ready to use the money and how to plan for that. Just like diversifying your investments to reduce market risk, diversifying your tax situation can help even out your taxes in the future. This means ensuring you have accounts with different tax treatments offering distinct tax advantages when designing your income distribution strategy.
If you have been saving diligently in a 401(k) or other tax-qualified types of investment accounts, you will need to consider how this could affect your income taxes in the future. Since you received a tax deduction when you contributed the funds, all the money you take out of these accounts in the future will be subject to income taxes. Required Minimum Distributions (RMDs) come into play later in life when the government requires you to take money out of this account and pay taxes that you’ve been able to avoid for so many years! Your social security payments and, if you are lucky enough to have a pension, will also count towards your taxable income in the future.
In addition to these tax-qualified accounts, putting your money to work in other types of accounts is important to diversify your future tax risk. These could be tax-free accounts, where contributions are made with after-tax dollars, and if certain conditions are met, no further taxes are due when you withdraw the funds in the future. Roth accounts and contributions made to your Roth 401(k) plan are examples of this type of account. Taxable brokerage account contributions are also made with after-tax dollars. The income generated and the gains realized by your investments each year are taxable in that same year and typically at preferred capital gains tax rates. These types of accounts can benefit retirees greatly by providing an opportunity to take distributions without having to pay income taxes at the time of distribution, like an IRA or 401(k) account.
The Bottom Line
Taxes, particularly in retirement, are a meaningful part of the risk you should plan for. Planning your future income strategy so that you understand how much you’ll need and how much of it will be taxed is critical since that tax burden directly impacts what you have left over to spend and how long your money will last. There are strategies you can undertake that can help you diversify your tax allocation and set you up to minimize taxes throughout your entire financial journey.
Brandy Branstetter, CFP®