Will my taxes go up or down in retirement?
Sneaky sneaky, asking such a loaded question, when everyone knows the answer is, “it depends.” But it’s a very interesting question to ponder, so let’s take a look at some key issues that could impact the answer.
The answer centers on one thing: income.
If you expect to have more income in retirement, your taxes may go up.
If you expect to have less or no taxable income in retirement, your taxes may go down.
Income is complex. There are several kinds of income, each taxed uniquely.
Ordinary, capital gain (short and long term) or tax-exempt. Then there’s adjusted gross income (AGI) and modified adjusted gross income (MAGI), which is some mystical calculation seemingly only software can compute for eligibility of credits, deductions or other.
In a previous column, I wrote that it is good to talk to a tax pro because what normal person really understands taxes? It can be complicated.
How much income will you have? And what kind of income is it?
Once you retire, you will have some control over how much and what kind of income you might have in any given year, even if you are one of the “lucky” employees at Pacific Northwest National Laboratory or some Hanford companies which still have pensions.
A pension (taxed as ordinary income) doesn’t have to start right when you stop working, contrary to common belief and practice.
Delaying the start of a pension by one or more years (Social Security benefits fall under this theory as well) allows you to create what I call a low- or no-income year, which opens a window of opportunity for realizing income in a controlled manner, and also controlling, and dare I say minimizing, your tax bill now and possibly in the future.
These opportunities include doing Roth conversions and donating to charity or a donor advised fund to offset some of the tax bill. Or selling off some of your big winners, realizing capital gains, then rebalancing, possibly being offset by some past losses. Or even just taking a taxable distribution from a Traditional IRA/401(k), minimizing the size of your IRA and future required minimum distribution, or RMDs.
Why would I want to do these things?
This is the game you are trying to play. Pay taxes in the year it makes the most sense for you. There are many reasons you might want to realize income and pay taxes now versus later or vice versa.
Why pay now?
- I’m in what I think is a lower tax bracket now (a low-income year) and will have higher income later.
- I think tax rates in general are going to go up. We have to pay off that national debt somehow.
- I want to pay taxes now and leave tax-free money to my heirs.
- I want to diversify the types of accounts I have (pre-, post- and tax-free) to have more flexibility in creating my retirement income.
- I want to pay a higher rate now on a smaller amount so that I might avoid paying even a low tax rate on a much bigger amount.
- I’m concerned that my higher future taxable income will increase my Medicare premiums (Medicare income-related monthly adjustment amount, or IRMAA, surcharge) or the taxable portion of Social Security, especially when one of us dies, and we start filing as single.
Why pay later?
- I expect to be in a lower tax bracket.
- I want to keep 100% of my money invested now instead of paying it out in taxes.
- I have no heirs. Or, I’ll leave appreciated assets to my heirs, who get a step up in basis.
- I will likely donate much of my appreciated wealth to charity by gifting assets or making qualified charitable donations (QCD) thus paying no taxes.
- Because this is my life, my goals, and my decision!
By the time you turn 70, you will have started receiving Social Security, and at 72, receive and pay tax on RMDs from retirement accounts. Both are taxable events and worth planning for.
Current vs. future tax law
The decisions we make today are made with an unclear image of the tax future. Uncle Sam is privy to making quick and impactful decisions that can make future tax projecting and planning tricky. Sometimes it makes more sense to make decisions based on the current law instead of what we think may happen in the future.
That is a big benefit of having a diversified tax plan: no matter what happens, you have options.
Saving on taxes
Oftentimes the focus of tax planning is on saving taxes. I’d argue that the focus should be on making the best tax decisions for your situation and your short- and long-term goals.
Sometimes you have to just take a leap, commit and pay tax at the rate that seems the best option at that time unless you happen to have a crystal ball and can see into the future.
Right now, we sort of have a way to look into the future. We know that the Tax Cuts and Jobs Act will cause tax breaks to expire at the end of 2025. Unless Congress steps in and extends or modifies the law, for some, taxes will go up.
Taxes aren’t everything
Taxes certainly come into play when making financial and retirement decisions but need not be the only or even the key deciding factor.
The main thing is to pay attention to opportunities throughout life that may impact taxation, be mindful of employer-sponsored tax-preferential programs and plan your tax strategy for the long-term just like you do with your investment strategy.
Making tax-smart decisions all along will ensure a great outcome while you are working as well as in retirement. And, you might even save on taxes.
Angie Furubotten-LaRosee is a certified financial planner, speaker, podcaster and founder of Avea Financial Planning LLC, a Richland firm offering fiduciary financial advice and investment management for a flat fee, specializing in retiring folks, especially from Pacific Northwest National Laboratory.