Do Tax Rates Go Up or Down in Retirement?

Posted: February 19, 2012 at 10:04 pm


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The decision about whether to opt for Roth tax treatment of your retirement assets--where you pay taxes upfront in exchange for tax-free withdrawals later on--requires you to make a judgment about whether your taxes will be higher in retirement than they were while you were working.

That's a lot harder than it sounds, as my colleague Adam Zoll explored in this article (http://news.morningstar.com/articlenet/article.aspx?id=537102). Not only does itinvolve divining what tax rates are apt to be on a macroeconomic level by the time you retire, but you also need to bear your own personal situation in mind. For lower earners who are early in their careers, it's likely that their income tax brackets will be higher in the future than they are today, making Roth contributions and conversions a good bet. For older savers, that might not be the case.

To help gather insights into the latter question, I recently surveyed Morningstar.com's many retired readers about their tax experiences, both pre- and post-retirement. Posting in the Investing During Retirement section of Morningstar.com's Discuss boards. I asked them whether their tax rates had gone up or down during retirement. Posters shared their own observations and how they navigated the "to Roth or not to Roth" question themselves. Several posters also weighed in with their own strategies for keeping their in-retirement tax rates down. Click here (http://socialize.morningstar.com/NewSocialize/forums/p/299270/3200784.aspx#3200784) to read the complete thread or share your own experience.

'My Retirement Tax Bracket Is Radically Lower'
Many posters noted that their in-retirement tax brackets were lower than when they were working, and that was, at least in part, by design. Several retired or soon-to-be retired readers said their lower earned incomes in retirement had helped; others noted that they had taken maximum advantage of asset location and tax-advantaged investments such as municipal bonds to limit their in-retirement income. However, posters' responses also alluded to the fact that managing tax brackets becomes more difficult past age 70 1/2, when seniors are required to begin taking minimum distributions, or RMDs, from their traditional IRAs and 401(k)s; those distributions are taxable.

Capecod's response to my query was unequivocal: "My retirement tax bracket is radically lower than pre-retirement. That is a consequence of one, no work compensation/earned income; two, living off Social Security and a portfolio composed largely of tax-free munis; and three, holding growth and higher-yielding taxable assets in an IRA with mandatory distributions still several years in the future."

Hanneral has employed similar strategies--and a few others--to keep taxes down in retirement. "My tax rate has dropped a lot [in retirement]. I have moved many of my high-return stocks to the tax-deferred account. I also added a number of munis to my holdings several years ago while their rates were more favorable. I also make maximum use of opportunities like donating unused time-share properties to charity. I have been retired now for 14 years and these steps have aided in keeping my tax rate low."

The same holds true for ThePrune, who shared, "Before retirement our married filing jointly tax bracket would have been 28%, but by making use of tax-deferral savings such as 401(k), 403(b) and 457 plans, we were able to push ourselves down into the 25% marginal tax bracket. After our recent retirement our marginal tax rate rate has dropped from 25% down into the middle of the 15% bracket. And I have a long-range tax planning strategy to keep it in the 15% bracket, even once required minimum distributions begin."

Hoodee is using a similar playbook: "My tax bracket went down dramatically and has stayed down in the 12 years since retirement. I can manage my investments to time capital gains so that I pay little in taxes; also, when I was working, my adjusted gross income was much higher."

Snorton is taking tax management a step further still: "I'm not yet retired, but I expect to pay less tax because I will be able to control how much I draw from taxable assets, unlike now where everything is taxed. I hope to change our official residence to a tax-free state where we have a second home to escape California's 10% (and rising) tax."

Poster audreyh1, who also participates in the Early Retirement Forum, has observed it's not uncommon for tax rates to go down during retirement. She wrote, "Many retirees seem to be able to stay in the 15% tax bracket. It may also be that some are receiving part of their income as capital gains and qualified dividends which are taxed at the 15% rate. Some of retirees have reported that they way overestimated the taxes portion of their retirement budget."

Audreyh1went on to provide a few additional reasons that retirees often see their taxes decline. "The total tax burden drops as well as a retiree is no longer paying Social Security or Medicare taxes. During the past decade, the amounts an older investor can put aside into tax-deferred retirement accounts has increased a lot. Back in the 1990s, the amounts that could be tax-deferred were much more limited. So perhaps newer retirees won't see such a drop in taxes if they were able to invest heavily in tax-deferred accounts before retiring."

Rossinator, with a big share of overall assets in taxable accounts, exemplifies Audrey1's point: Those with taxable assets can take advantage of a variety of maneuvers to keep taxes down, something those required to take RMDs cannot do. "My taxable investment account is a good deal larger than my retirement account (now a Roth IRA). The good news about this is that I can pass the Roth on to my heirs (hopefully), and I can manage my capital gains in my taxable account. I have been looking at my taxes for 2011 and noticed that my capital loss carry forward will run out on the 2011 tax return. So I won't have an extra $3,000 to deduct from income in 2012, but my tax rate in future years should still be substantially lower in retirement."

For Morningboy1, lower in-retirement tax rates are, at least in part, a sign of the times in which we live. "My tax rate went down because the interest rate went down and some banks went bust."

'It Is Hard to Reduce Our Taxes as Some Have Done'
Other posters, meanwhile, haven't seen a substantial change in their tax rates in retirement relative to what they paid while they were working. Those retirees who are deriving a big share of their income from pensions, RMDs from traditional retirement accounts, and Social Security were the most likely to report that their tax rates had stayed the same or even gone a little bit higher in retirement; they exert less control over their income streams than those retirees with big shares of their portfolios in taxable accounts and those who have yet to start taking RMDs.

For poster DennyF, keeping taxes--and income--level was part of the plan. "Our marginal tax rate (25%) has remained the same. But that was an expected outcome of our financial planning. Our goal was to work until our pension and Social Security benefits matched our pre-retirement income."

The same goes for Hondo, who noted, "We have remained in the same tax bracket that we were in before retirement. We both receive pensions and RMD income, plus I have Social Security, and we must take the standard deductions on our tax return. Therefore, it is hard to reduce our taxes as some have done."

Mdgardner concurred. "Our rate is about the same as before retirement. Most of our income is from combined pensions and Social Security and puts us into the 25% bracket."

Nittwit's post hints at the fact that for many seniors, retirement doesn't mean completely saying goodbye to the workaday world, and that can increase the tax bill. "I am retired 'on and off,'" this reader wrote. "This means that when managing my property and finances leaves me with too much free time, I seek employment. My wife is 10 years younger and loves to work and works for good people (boy does that make a difference), and so for tax purposes we still work. Our effective tax rate according to Turbo Tax for 2010 was 14.5%. My projections do not see that effective rate changing when we both retire although our official tax rate will decrease."

Mjlevine, like Nittwit, has also continued to work, which in turn has had implications on the tax front. "No one seems to consider the person who chooses never to retire because they love their work! I'll be 70 1/2 this year and will have to start taking RMDs. I'll still be earning as much as before, part of my Social Security is taxable, and I'll owe tax on my distributions. My bracket will therefore actually be higher!"

'So Far So Good'
Posters also weighed in on the pros and cons of converting traditional IRA and 401(k) assets to Roth status; doing so will reduce in-retirement tax bills and reduce the amount of money that must be distributed during their lifetimes. (Owners of Roth IRA accounts, in contrast with traditional IRA owners, are not required to take taxable required minimum distributions.)

Dipiranha notes that the ability to take tax-free IRA distributions keeps in-retirement taxes at or close to zero. "Before I retired two years ago, I was paying about 25% Federal, 14% self employment tax, and 9% California tax. Seventy percent of my money is in a Roth and 30% in Taxable IRAs. I pull just enough out of my taxable accounts to avoid any tax and the rest of my yearly expenses comes out of the Roth."

Poster WOODJ believes the decision to convert traditional IRA assets to a Roth IRA has helped increase in-pocket income during retirement. He shared his complete strategy for reducing in-retirement taxes in the thread, concluding. "Paying no taxes means that all of our income can be spent on the good things in life."

Jomil has also been pleased with the decision to convert: "I converted the last of the 'alphabet soup' of deferred compensation plans and IRAs to Roths in 2010. So far no regrets or worries about 'what ifs.'"

FidlStix, not yet retired, thinks that the possibility of higher tax rates in the future bolsters the case for converting traditional retirement vehicles to Roth. "Since taxes are sure to go up substantially in the years ahead, I'm thinking hard about biting the bullet and rolling 10% of my 401(k) into my Roth (backdoorwise) when I retire."

Paulbrown notes that being in a low tax bracket when the conversion takes place can make a conversion advantageous; his post also alludes the fact that reducing taxable income from other sources reduces the taxation of Social Security benefits. "I thought the only advantage [to conversion] was that it would lower my RMD, and I may never have to take more than what is required. When I did [the conversion] seven years ago I was already in the 15% bracket with no earned income, only Social Security, and RMD from IRAs. I was hoping I could also have less than 85% of our Social Security that was taxable. So far, so good."

Scotty believes that estate-planning considerations bolster the case for converting to Roth status. "With the Roth IRA the returns can be passed on to their children as tax-free extensions since the tax has already been paid upfront. At least this is with current law."

For texasboy, the decision to convert was driven by his desire for tax diversification--the ability to draw assets from vehicles with varying tax treatment. "I believed in spreading investments out among vehicles so I have traditional/Roth/401/403(b) depending on my ability to fund in any given year. That way I can pull from vehicles as each year's needs dictate would be best."

Both estate planning and tax diversification played a role in Rule72's decision to convert part of the household's IRA assets. "I will probably stop conversions once we are about 50/50 split in the Roth versus a traditional IRA. At least in our case it appears beneficial to pay more taxes now so 'the family' can pay less overall. And since we won't convert 100% I guess that means we've hedged our bets on the future taxing of tax qualified accounts. I reserve the right to adjust my spread sheet and change my opinions as the tax rules change."

Other posters weren't as sold on the benefits of converting traditional IRA assets to Roth. Hondo wrote, "I did convert some traditional IRA money to Roth before retiring. Looking back, I'm not sure that was a wise decision. Perhaps Roth conversions are good if the person is young, but I now feel it is unwise if the person is near retirement. In general, I don't believe in paying a tax before you have to."

Capecod was on the same page, noting that the appropriateness of a Roth conversion varies by individual. "For what it's worth, I've never understood the appeal of converting a traditional IRA to a Roth, but perhaps those with higher net worths see tax/estate planning advantages that don't apply to my family."

Johnep also did the analysis and concluded that Roth conversions weren't for him. "I went from top of 25% bracket to mid-point. Using pension and Social Security now but [being required to take] RMDs in a few years will put me back in high range of 25% bracket. I looked very closely at Roth but could not see the benefit starting now. A clear benefit for those starting much younger."

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Do Tax Rates Go Up or Down in Retirement?

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February 19th, 2012 at 10:04 pm

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