By Stephen W. Bedikian, Associate Wealth Advisor
Key Takeaways
- Your retirement tax rate depends on more than your income. Your assets, income sources, Social Security benefits, and state of residence can all affect your tax liability.
- Future federal tax rates are impossible to predict. Tax rates have changed significantly over time, so assuming today’s rates will remain in place throughout retirement can be risky.
- Where you live can make a meaningful difference. State income tax rules vary, and some states don’t tax retirement income or Social Security benefits.
- You have several ways to manage your tax liability. Municipal bonds, charitable giving strategies, and Roth conversions can all play a role in managing taxable income.
- Tax planning should begin before retirement. The years between leaving the workforce and beginning RMDs can create opportunities to make strategic Roth conversions and aim to reduce future taxable income.
- Retirement tax planning is an ongoing process. Reviewing your options each year can help you respond to changes in your income, tax laws, and financial circumstances.
How Is Your Tax Rate Determined in Retirement?
Your tax rate in retirement will depend on the specifics of your situation like types of income and assets but it will also be influenced by the tax planning choices you make both before and during retirement. Knowing what levers you can pull to help manage your annual tax liability means you can equip yourself with tools you may need in the future.
Historically, one of the fundamental assumptions of financial planning has been that your tax rate will be lower during retirement. This seems intuitively obvious: You won’t be working and getting a regular paycheck – and Social Security was never designed to fully replace lost wage income.
The reality is more complicated. Your retirement tax rate will be determined by a variety of factors including: where you retire; what types of assets you own (taxable versus non-taxable) and the value of those assets; other income sources such as rental or pension income and Social Security; and perhaps most importantly – prevailing tax rates during retirement.
What you can’t predict: Federal tax rates
The federal government’s debt currently stands at about $40 trillion dollars. We’re running a multi-trillion-dollar annual deficit, so we’re rapidly increasing that already large debt. Interest payments on this debt already exceed the annual appropriation for national defense, which used to be the largest category of federal government spending.
The top marginal tax rate is currently 37%, but back in the 1970s, it was 70%. There is a distinct possibility that future tax rates will have to be increased to address our nation’s financial situation.
Tax Rates for Retirees Differs by State
There is no crystal ball to predict future federal tax rates. But there are factors to consider that you can control. This includes where you choose to live during retirement.
If you’re a California resident with a $2 million IRA balance, you’re likely to fall in the 9.3% state tax bracket. This means that if you fully deplete that account during your retirement, while remaining in the 9.3% bracket, you will be paying about $186,000 more in taxes than if you retired in a state like Texas or Florida that doesn’t have a state income tax.
And of course, if you have investment income like dividends or interest, then you will incur state income tax on that income in addition to the income from your IRA’s distributions.
Social Security tax rates for retirees
But there’s some good news for California residents. The state doesn’t tax your Social Security benefits – of course, neither does Texas or Florida.
Even though many states don’t tax Social Security benefits, the federal government does. The IRS calculates your “combined income,” which is your adjusted gross income + nontaxable interest (such as municipal bond income) + 50% of your Social Security benefits.
For single filers with combined income: under $25,000 of income there is no tax; for $25,000 – $34,000, up to 50% of benefits are taxable; and for those with income over $34,000, up to 85% of benefits are taxable as ordinary income. For those married filing jointly with combined income: under $32,000 there is no tax; for $32,000 – $44,000, up to 50% of benefits are taxable; and for those with income over $44,000, up to 85% of benefits are taxable as ordinary income. If you’re married and filing separately, up to 85% of your Social Security benefits are taxable at any income.
Strategies for Managing Your Retirement Tax Rate
There are several levers you can pull to help manage your ordinary income and the associated tax rate during retirement. You can make some of those decisions annually during retirement; other tax-efficient retirement strategies require advance planning.
Consider Municipal Bonds
For example, during retirement, you could choose to increase your holdings of municipal bonds in your taxable accounts. You’ll generally earn a lower yield on those bonds, but they have the potential for triple-tax free treatment (exempt from municipal, state and federal taxes). Generally, triple-tax free treatment applies to bonds issued within the investor’s state of residence. However, municipal bond income may be subject to the Alternative Minimum Tax (AMT).
Thus, your taxable interest income would be lower, potentially reducing both your adjusted gross income (AGI) and your overall tax rate. This can amount to a meaningful difference if it helps your income fall into the 24% tax bracket – currently, the tax rate for the next highest bracket is 32%.
Use Charitable Giving Strategically
Another way to manage your annual tax liability is to bunch charitable donations into a donor-advised fund (DAF). If you typically make $5,000 in annual charitable donations and take standard deductions, you can bunch those donations into a single year, contribute $25,000 (or more) into a DAF account and itemize in that year.
You will then realize that full deduction amount even if you just take out $5,000 each year from the DAF for the next five years to make your usual annual donations. That itemized deduction could push you into a lower tax bracket for that tax year.
Consider Roth Conversions Before RMDs Begin
Some strategies like Roth conversions from a traditional IRA are most effective if implemented during the period before required minimum distributions (RMDs) begin.
People often retire around age 65 and start taking Social Security benefits at age 70 and RMDs at age 73 (or later; the age requirement is based on your year of birth). This period of relatively low income – often referred to as the ‘retirement valley’ – can be an optimal time for Roth conversions: You don’t have a regular paycheck, so your tax rate is likely low. If you do so, you’ll pay income tax on those Roth conversions, but you’ll lower the balance of your traditional IRA – and thus the future taxable RMDs from that account.
Roth accounts don’t have an RMD, and withdrawals you make from these accounts aren’t taxable after you’re aged 59 1/2 (and after you meet the IRS’s five-year holding requirement). This helps lower your taxable income in retirement.
Planning for Your Future Retirement Tax Rate
Though we can’t predict what tax rates will be when you retire, we can help you project your expected income in retirement, and the likely tax hurdles you’ll face. More globally, we can advise you on prudent steps to take both before and during retirement in an effort to minimize your tax liability.
At a mid-year tax planning meeting, your HH advisor can help review the specific options available to you each tax year.
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