People often go into retirement thinking their biggest expense at that stage of life will be health care.
But they (and you) may be surprised to learn that, in many cases, the actual biggest expense is something quite different — income taxes. Those who aren’t prepared for the role the IRS will play in their retirement are at risk of taking a big hit — a hit that could have been prevented.
And as time goes by, the situation is likely to get worse. To understand why income taxes could become an even more significant concern for future retirees than current ones, you need to look at federal spending and the ever-growing interest on the national debt. The Committee for a Responsible Federal Budget recently reported that, according to the latest projections from the Congressional Budget Office (CBO), the net interest on the national debt “will amount to an eye-popping $10.5 trillion over the next decade.”
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At some point, someone will need to pay that debt. And that someone is going to be you — an American taxpayer.
It’s a big problem — one that’s been lingering for a while.
As far back as 2011, David Walker, who served as comptroller general of the United States and head of the Government Accountability Office from 1998 to 2008, said in a CNN interview, “Regardless of what politicians tell you, any additional accumulations of debt are, absent dramatic reductions in the size and role of government, basically deferred tax increases.”
Around 2008, then-U.S. Rep. Paul Ryan of Wisconsin asked the CBO to estimate the impact of raising marginal tax rates to pay for the projected spending in decades to come on Medicaid, Medicare and Social Security.
The CBO estimated that the “tax rate for the lowest bracket would have to be increased from 10% to 25%; the tax rate on incomes in the current 25% bracket would have to be increased to 63%; and the tax rate of the highest bracket would have to be raised from 35% to 88%. The top corporate income tax rate would also increase from 35% to 88%."
In other words, at every level, tax rates would more than double.
The other part of the problem
Not exactly something to cheer about, and most retirees aren’t going to be in a position to take the blow to their annual budgets that such tax increases would cause.
Of course, what drives the amount of taxes you pay is your taxable income, and that represents the other part of this problem. In retirement, most income comes from Social Security, a pension and withdrawals from retirement savings, such as a traditional IRA or 401(k). All that money is subject to being taxed, and it is taxed as ordinary income.
Sometimes people are surprised Social Security is taxed at all. It isn’t always, but up to 85% of it can be taxed if your combined taxable income is more than $34,000 for an individual or more than $44,000 for a couple filing jointly.
Something else that comes into play here for retirees is Medicare, which people qualify for once they turn 65. Medicare is not free at age 65. You pay for it every month, usually through withholding an amount called IRMAA (income-related monthly adjustment amount) out of your Social Security check. But when your taxable income goes over a certain threshold, an extra surcharge kicks in, which can increase what you pay each month for Medicare by as much as 339%. That’s another reason to keep your taxable income as low as possible.
What can be done about it
But enough about the problem. The question is, what can we do about it? Here are a few suggestions:
Shift money to a nontaxable account. If you have a traditional IRA or 401(k) account, where taxes have been deferred until you start withdrawing money in retirement, you have an option. You can leave the money there, and the taxes will come due (including required minimum distributions, or RMDs, when you turn 73) at whatever rate the government decides, or you can start transferring that money into a Roth account.
You will pay taxes as you make the transfer, but your money will then grow tax-free, and you will pay nothing in retirement when you withdraw. You may want to stretch those transfers over several years, so you avoid jumping yourself into a higher tax bracket.
Recognize that there are no limits on Roth conversions. Sometimes people erroneously think there is a limit on how much money you can convert to a Roth in a given year. That is not the case. There are limits on Roth contributions — $6,500 annually if you are younger than 50; $7,500 if you are 50 or older. But when you are converting from a traditional account to a Roth, there are no limits. You could convert $1 billion in a year if you wanted and had that much.
In the tax code, there are seven income tax brackets, and I usually recommend topping out your bracket when you do a Roth conversion, so you are getting as close as you can to the next bracket without venturing into it. An exception is if you are in the 22% tax bracket. The next bracket up, 24%, is such a small percentage increase that it’s OK to voluntarily jump to that if you want to convert more money.
Consider investments that aren’t taxed as ordinary income. As mentioned earlier, one disadvantage to retirement income that comes from Social Security, pensions and retirement accounts is that all of it is taxed as ordinary income. But the profits you get from selling some other investments, such as stocks, bonds and real estate, are taxed as capital gains.
Unlike with ordinary income, there are just three tax brackets for capital gains tax, and one of those brackets is zero. That’s right. No taxes at all. So, you should look at investing money in areas that are taxed as capital gains rather than ordinary income, and ideally you would like to get into that zero bracket.
All of this is why it is important, as you make the final approach to retirement, that you start making decisions and clean up these issues.
You want to structure your income in a way that allows you to achieve the lowest possible tax rate. Accomplishing that will mean more money for you in retirement, more money for your heirs and less money for Washington, D.C.
Ronnie Blair contributed to this article.
The appearances in Kiplinger were obtained through a public relations program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.
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