Taxes in Retirement: Are They Really Worth Worrying About and What’s the Deal with the New Tax Plan?

How much do taxes in retirement really matter? And, will the new tax plan make a difference to you or not?  Like most retirement planning questions, the answer is “it depends.”  However, in most cases, taxes are a really big deal when it comes to retirement planning.
Taxes in RetirementTaxes in Retirement: Will You Keep More or Give More to Uncle Sam?
Retirement taxes can add or subtract thousands from your bottom line each year.  And, predicting how much you’ll spend on taxes over the course of your retirement can be extremely challenging.

Taxes in Retirement Can Be a Really Big Chunk of Your Budget

The average American pays about $10,500 a year in total income taxes — federal, state and local.  Of course, many households pay a lot more and some people pay nothing at all — depending on your income level.

Ten thousand dollars is a big chunk — about 14% — of the average budget.  So, if you think about it, taxes can be  a bigger lever in your budget than investment returns, cutting expenses or waiting to claim Social Security for a bigger benefit check.

As such, it is worth worrying about your tax bill in retirement.

Good News — Average Tax Liability Plummets in Retirement

Ten thousand five hundred dollars is the average tax bill for Americans of all ages.  However, here is some good news: the average tax liability falls rather dramatically as people get older.

According to the Bureau of Labor Statistics, the average tax bill by age is:

  • $16,339 for people ages 45-54
  • $12,660 for those 55-64
  • $5,871 for people 65-74
  • Only $1,432 for people over 75

Taxes fall as you get older primarily because most retirees have less taxable income. And, there is a lot retirees can do to manipulate their income to optimize for taxes. Here are 6 surprising tips for minimizing your retirement taxes (recently updated with the new Trump tax plan tax brackets).

Should You Worry About Taxes as Part of Your Retirement Plan

On the one hand, taxes generally fall in retirement.  On the other hand, they can still be a significant budget factor.

Darrow Kirkpatrick of Can I Retire Yet has done some really interesting analysis and came to the conclusion that it can often be incredibly important to do a good job of predicting taxes as part of your detailed retirement plan.

He says, “If you make a major mistake [about taxes], you could throw off your retirement calculations by a significant factor. My “One Retirement Number” article showed that for a typical couple in retirement, the effective tax rate fluctuated dramatically — between zero and 23.8% — and there was NO simple single number you could choose to give the correct answer over an entire retirement! (Stuart Matthews of Pralana Consulting estimates that for each 1% error in effective tax rate, you introduce an 8% error in your final savings balance.)”

How in the World to Project Tax Liabilities for Every Year of Retirement?

A simple retirement calculator is NOT going to help you accurately predict your tax liability for the 20 to 30 years you spend in retirement (and the years from now until retirement).  You need a much more sophisticated, detailed and personalized model.

While far from perfect, the NewRetirement retirement planning calculator attempts to at least calculate a credible estimate for what you will pay in taxes each year.

This sophisticated system:

  • Allows you to set different levels of income throughout retirement to approximate your tax bracket for each year. Additionally, it allows you to specify if annuity and/or pension income should be taxed.
  • Lets you specify how much of your savings are in different types of taxable and non taxable accounts and it automatically calculates the tax liability (or lack thereof) for each account, as well as tax deduction handling of contributions.
  • Estimates required minimum distributions (RMDs) from retirement accounts starting at age 70.5 – a significant lever when it comes to tax liability in retirement.
  • Calculates investment returns on after-tax savings are taxed as long-term capital gains, not income.
  • If you are considering a Roth conversion, the calculator will estimate the tax hit in the year of the conversion as well as the benefit down the road when you draw from the Roth account.

For a full listing of the current tax rules in the system, which are regularly being updated, visit the Assumptions page after logging in.

A Few Considerations About the New Tax Plan

As if taxes weren’t already complicated, Trump’s new tax plan reshuffles the deck a bit so what you knew about taxes is now different.

The net effect of all of the new tax changes may be that — for the next few years — some households will see marginally lower taxes.  While these cuts are set to expire in 2025, who really knows what will happen between now and then.

Below is a list of a few confirmed changes and potential realities that might be of particular interest to retirees.  For a more comprehensive list, see: What’s in the Tax Bill, and How It Will Affect You:

Implications for Social Security and Medicare: Because the new tax plan proposes to add at least $1.5 trillion to the national debt, there is credible fear that cuts will need to be made to Social Security and Medicare.

Changes to the Inflation Index Could Move You into Higher Tax Brackets Over Time: The index that will be used to make inflation adjustments to tax brackets and other inflation related aspects of the tax code will change from the standard Consumer Price Index (CPI) to the chained CPI.

This is a bit of a stealth hit to the middle class.  According to the Tax Policy Center, “changing the inflation index would raise about $125 billion over the next decade and nearly $500 billion in the decade after that.”  The LATimes reports that “Most of that money would come out of the pockets of middle- and working-class taxpayers. Most important, it would slow inflation adjustments to tax brackets. This would hurt those taxpayers because more of them would move into higher brackets purely because of inflation of wages.

Medical Expenses: There is a tiny bit of good news for the next two years with regards to taxes and medical expenses.  In 2017 and 2018, you can deduct out of pocket medical expenses that exceed 7.5% (down from 10%) of adjusted gross income.

State and Local Taxes:  The legislation sets limits on the amount of state and local taxes that people can deduct. Beginning in 2018, couples filing jointly will be limited to an annual deduction of no more than $10,000 worth of state and local income, sales and property taxes.

Tax Brackets:  Income levels and tax rates are being adjusted for all 7 brackets, lowering the tax rate on taxable income for most individuals and families.

Standard Deductions: The standard deduction is temporarily being increased to $12,000 for singles and $24,000 for married couples. However, personal exemptions, which are 4,050 per individual in 2017, will no longer be available.

Obamacare and the Individual Mandate: There is now no penalty for not having health insurance.  This may mean that health insurance premiums will be more expensive for people who want insurance — potentially making it more expensive to retire early.

Estate Taxes: Good news if you hope to pass on more than $5,490,000 to your heirs.  Now you can pass on up to $10 million tax free.

Roth IRAs: Previously you were able to reverse a Roth conversion if the value of the account fell or some other circumstances changed.  You can no longer redo or undo a conversion.

Alimony: Divorce rates are skyrocketing among retirees.  So, it is important to know that taxes on alimony are changing significantly with the new tax bill.  Alimony payments are no longer tax deductible for the spouse who pays.  And, the person who receives alimony will not have to pay tax on that income.

Moving Expenses: Downsizing is common in retirement.  However, moving expenses will no longer be deductible.

Buying a New Home: If you are planning to move in retirement, you will want to be careful about how much you are willing to pay for a new home.  If you take out a new mortgage on a first or second home you will only be allowed to deduct the interest on debt up to $750,000, down from $1 million today. Homeowners who already have a mortgage are unaffected by the change.

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