A recent retiree expressed her opinions about her retirement income and she said, “Tax deferral was the worst advice I have ever received!” What does she mean? How could tax deferral be so terrible for retirees? Is it better to pay our taxes now or pay later?
Lesson # 1 Tax Brackets
Today we are in a historically low tax bracket environment. It may not seem like it, however, we have had lowered tax brackets since 1986 when the top marginal bracket was 50%. Since then our top tax rates have decreased with a top marginal rate of 39.60%. So, anyone who has worked and since retired between 1986 and 2015 is virtually in the same tax bracket. There are no separate tax tables for retirees, and if you have saved well, chances are you are in the same bracket as when you were working. There is absolutely nothing guaranteed about what tax bracket you will be in during retirement. Withdrawals from tax deferred retirement plans are added to your income.
Lesson #2 Taxation of Social Security Benefits
Retirees didn’t always pay taxes on their social security benefits. Taxation of benefits begin in 1983 as a result of what is known as the “Greenspan Commission”, a committee headed by Alan Greenspan to make recommendations to solve the then short-term social security crisis. When the new law was signed and enacted in 1983, married couples with combined incomes of over $32,000 were subject to a portion of their social security benefits being taxed. Guess what? The threshold of $32,000 remains 32 years later. It has never been adjusted or indexed. Virtually all individuals pay or will pay tax on their social security benefits. Withdrawals from tax deferred retirement plans will increase your income.
Lesson #3 Determining Your Medicare Premiums
If you have higher income, the law requires an adjustment to your monthly Medicare Part B (medical insurance) and Medicare prescription drug coverage premiums. Higher-incomes will pay higher premiums for Part B and prescription drug coverage. While the income thresholds for paying this premium are high (individuals with incomes over $85,000 a year and couples with income over $170,000 a year), you would have to take into consideration what income could put you into this threshold. For example, a widowed individual with $60,000 of annual income is now over 70½ and has to take a required distribution from her $420,000 IRA – that puts her right over the $85,000 threshold and will increase her Medicare premiums.
Lesson #4 Withdrawing from Tax Deferred retirement plans
Based on the three lessons above, you now know that having a higher income will potentially affect taxation of your social security benefits and maybe your Medicare premiums. Then you also have to consider how much you withdraw from your tax deferred accounts. Taking large lump sum distributions could push you into a higher bracket. Currently our brackets jump from 15% to the next level of 25%. You could decide not to take withdrawals, except that the government forces you to do that at age 70½. Tax deferral over 30 or 40 years takes its toll when it comes to taking your required minimum distributions. For example, a $500,000 401k balance at age 75 would force you to take out $21,800 which will be added to your income.
Lesson #5 ROTH 401ks
When you defer taxes for 30 or 40 years, you have an unknown tax liability. Wouldn’t it be easier to pay your taxes now, while you are working instead of when you are retired and on a fixed income? ROTH 401k plans became available in 2006. Employees now have a choice of contribution after-tax dollars for their retirement or the traditional pre-tax contributions. If that same 70½ year old had a $500,000 ROTH 401k, there would be no required minimum distribution at any age. There would be no additional income to declare that could affect your social security or Medicare premiums. And even better, ROTH money will pass tax-free to your beneficiaries.
There are many lessons to learn about saving for retirement and you should sit down with your financial advisor and tax professional to see what makes the most sense for you in the long run.
Roberta L. Nestor is a financial advisor practicing at 491 New Haven Avenue in Milford, CT offering retirement, long term care, investment and tax planning services. She also offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network – a member FINRA/SIPC and a Registered Investment Adviser. Fixed insurance products offered through Nestor Financial Network are separate and unrelated to Commonwealth. Commonwealth Financial Network or Nestor Financial Network does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation. Roberta can be reached at Nestor Financial Network, 203-876-8066 or email@example.com.