A Dangerous Retirement Myth

Many retirement plans fall short of their goals because they were built on myths and misunderstandings. Most of my work at Retirement Watch falls into two categories. The first category is determining changes that should affect retirement plans. The second category is correcting the myths that have built up around retirement planning. One of the great myths of retirement planning is: Taxes will be lower in retirement. Last week we had tax return deadlines and tea parties, so this is a good time to discuss the issue of taxes in retirement, and a new survey proves a point I have made for years about retirees and taxes.

There was a time when taxes really did decline in retirement. When income tax rates were higher and there was a heavily graduated tax system, there were 13 tax brackets. Many people received less income in retirement than during their working years, and it did not take much of a drop in income to push a new retiree into a lower tax bracket. In addition, there were numerous tax breaks for seniors.

Things are different now.

We have only a few tax brackets. One needs to have a significant drop in income after retiring to drop into a lower bracket.

More importantly, retirees are making up a larger share of the taxpaying public as the Baby Boomers age. Governments cannot afford to let them pay less in taxes, and they do not.

Social Security benefits once were exempt from income taxes. For a while now, the benefits have been taxable to “upper income” recipients. The number who pay taxes on the benefits rises each year, because the income levels at which the benefits are taxed are not indexed for inflation.

Many retirees also are likely to be caught in the alternative minimum tax. Each year, more middle income retirees pay higher taxes under the AMT than under the regular income tax. That is usually because income declines after retirement but tax deductions remain the same. The combination can trigger the AMT.

In fact, unknown to many pre-retirees, taxes are likely to be your largest expense in retirement. While most people worry about medical expenses and long-term care, the biggest drain of your retirement income will be taxes. Income taxes are likely to take the largest share. There also will be sales taxes, real estate taxes, personal property taxes, and taxes on capital gains.

The new survey of retirees between ages 70½ and 75 with a net worth of at least $1 million, by Securian Financial Group, found taxes were the largest expense by a wide margin. Taxes, in fact, took about 4% of net worth every year. That is 4% of net worth, not of income. The percentage of income taken by taxes is much higher. It is tough to have net worth increase or remain stable when one expense is taking such a large portion. 

Tax planning needs to be an integral part of your retirement money management. Strategies that effectively reduce taxes for many retirees include:

Tax-exempt bonds instead of taxable bonds. These won’t help reduce taxes on Social Security benefits, but they will reduce income taxes. Tax-exempt bonds carry attractive yields relative to treasury bonds now, but they also carry extra risks because of the economic distress of many state and local governments. Don’t take high risks to reduce income taxes.

Monitor the stealth taxes each year. Relatively small adjustments in income or expenses in the last part of the year might avoid higher taxes due to the itemized expense reduction, the personal and dependent exemption phaseout, and the alternative minimum tax.

Investments. Simple strategies such as minimizing trading, holding investments more than one year so the capital gains are long-term and not short-term, and buying mutual funds that traditionally make low annual distributions are easy ways to boost after-tax investment returns.

IRA management. Once distributions begin, managing the IRA is more complicated than many people realize. Taxes can be reduced and the life of a portfolio extended by withdrawing money from your different accounts in the right order and carefully calculating which assets are held in which accounts. Some retirees reduce lifetime taxes by taking money out of their IRAs faster than required under the law or converting a traditional IRA to a Roth IRA.

Maximizing deductions, such as those for charitable contributions and medical expenses, also are key to reducing taxes for many retirees.

Many retirees are surprised by the amount of taxes they pay. They believed the myth that taxes decline in retirement. The truth is without some planning taxes will stay the same or even increase during retirement. Tax breaks specifically for seniors are rare these days. Tax traps and a retirement tax ambush are more likely. You need to continue tax planning through retirement to ensure your retirement fund lasts a lifetime.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com. He also is author of numerous books and reports, including The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Posted 04-17-2009 10:15 AM by Bob Carlson