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Retirement Savers’ Most Taxing Misconceptions

Updated: Dec 8, 2020

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How will taxes impact retirement? This is one of the least asked questions by retirement savers but one whose answer can have a significant impact on their ability to retire in comfort. The road to retirement is pave with many misconceptions. Taxes, unfortunately for naïve retirement savers, appear to be at the center of most of these fallacies. Before one can address these delusions, one must enumerate them. You can’t solve a problem you don’t know you have.

It’s not a question of whether or not you pay taxes, as the concept of the oft-repeated phrase “tax-deferred” is generally well understood. It’s therefore not a matter of “if” as it is “how much.” “Death and taxes are inevitable,” says Timothy Yee of Green Retirement Inc. in Alameda, California. “In the case of taxes, the question is: When do you want to pay said taxes? Factored into this is the question of when will you retire.”

More interesting than the intellectual acceptance of paying taxes in retirement is the psychological acceptance. Remember, retirement savers have spent their entire career making tax deductible contributions, so their mindset may linger on tax reduction well beyond their employment. “Their previous planning in deferring taxes for a future date just became to reality,” says Brett Anderson, President of St. Croix Advisors in Hudson, Wisconsin. “They made a deal with the government, and they will collect taxes. Now the real question is: How much and when? That’s when the planning starts because when they enter the distribution phase, now how do we minimize taxes?”

Let’s not put the cart before the horse. Before we consider ways to minimize retirement taxes, we need to consider the source of those taxes. By far, many already assume they will see “income tax on retirement funds, such as 401k’s, IRA’s and pension plans and on social security plus property taxes on home,” says Tom Wheelwright, a CPA and Author of Tax-Free Wealth who lives in Phoenix, Arizona.

“Generally speaking,” says Chad Smith, Wealth Management Strategist with HD Vest located in Irving Texas, “retirees’ taxes can be broken into three categories: Federal income tax, State income tax, and property tax. Income tax planning is the most important because it is one of the highest expenses for retirees so careful attention should be paid here. Property tax rules vary from state to state – so this depends where the retiree lives.”

For the most part, though, retirement savers, as they head towards retirement, pay particular attention to the taxes generated from their retirement plans. “Most people expect to pay some federal income tax,” says Rick Rodgers, from Lancaster, Pennsylvania and author of Don’t Retire Broke: An Indispensable Guide to Tax-Efficient Retirement Planning and Financial Freedom. “It’s generally understood that withdrawals from retirement accounts are taxable and the amount of tax will depend on the size of withdrawals each year.”

In these terms, withdrawals from retirement plans are treated just like salaries, with your taxes “calculated based on your total income and reduced by eligible deductions,” says Tony Mahabir, CEO of Canfin Financial Group based in Toronto, Ontario, Canada. “Typical payments that are expected to be taxed during retirement: Pension Income and Social Security income, Investment Income like interest and dividends and capital gains including the gains you made when selling your home if the gains are above $250,000 (single) and $500,000 if married. IRA and 401(K), 403(b), and 457 plans including Annuity Income.”

Here’s where things start to get tricky, as actual events tend to exceed tax expectations. “They expect to pay taxes,” says Anderson, “but the reality of their previous planning (or lack thereof, as is usually the case) doesn’t hit until retirement because they’ve delayed paying taxes for 25, 30 years. Meaning for most individuals 100% of their income in their retirement years is taxable income.”

Sometimes this disconnect comes from the misunderstanding that tax rates fall because you older. “In relation to taxes,” says Brett Moore, Managing Vice President – Appreciation Insurance & Financial Services, LLC in San Diego, California, “I believe a common misconception is retirees believe they will pay less in taxes during retirement. However, we constantly remind our clients that income taxes are based upon income, not age. A majority of retirement income is based upon a pension or a qualified program like an IRA, 401k, or 403(b). Retirees also have additional factors like fewer dependents and less mortgage interest.”

In a sense, it appears the real-world diverges from the world of those employee education sessions. You know the ones, they’re the ones that highlight the “benefits” of tax deferred saving. It turns out, when one hits retirement age, the nature of those benefits may be slightly altered.

“I can tell you the textbook answer to this and what I used to believe and then what I believe now,” says Craig W. Smalley, CEO of CWSEAPA with offices in in Florida, Delaware, and Nevada. “Most income that is made in retirement is through SS, pension, IRA, or 401k. The theory was that you would contribute to these plans in your income earning years, get the tax deduction, and then when you retired your income bracket would be lower, and the taxes that you would pay would be lower. However, who knows what they are going to do with tax brackets anymore. I would rather use a combination of ROTHs which are not tax deductible, and then some in a tax deductible account. For instance, you have a client that is self-employed. They can start a 401k with a ROTH option and put up to $18,000 if under 50 into the plan. That is an after-tax contribution. Then with some of these plans, they can put up to 25% of compensation into the plan, which is on top of the $18k. The 25% is tax deductible, and therefore taxable when taken out. The ROTH portion wouldn’t be taxable.”
The good news is, when it comes to Social Security, many folks don’t have to worry about paying taxes on it. For those in the not so rarified air, it will be wrong to assume they’ll be seeing the full amount of their government check. “For the most part Social Security income isn’t taxable unless you have another source of taxable income,” says Smalley. “People are shocked when they learn a portion of their Social Security is taxable.”

Part of that shock may come from how amazing little one has to earn to find means-testing will begin to eat their Social Security away. “Most people fail to understand that Social Security benefits are subject to tax based on their other income,” says Rodgers. “Retirees with provisional income below the base amounts of $25,000 (single filer) and $32,000 (joint filer) are not subject to federal personal income tax on their Social Security benefits. Retirees with income above these thresholds will find that the tax applies to some percentage of their benefits. For joint filers with incomes above an ‘adjusted base amount’ of $44,000, up to 85% of benefits can be taxed.”

The next shocker comes from a lack of familiarity with how retirement savings plans are taxed. Moore says, “Most retirees fail to realize that because the above mentioned programs allow for tax savings (in the form of deductions) on the front-end (during the contribution phase), every dollar pulled from qualified programs (distribution phase) are subject to the applicable income tax rates for the year in which the withdrawals are made; the back-end.”

This can throw a monkey wrench in those back-of-the-envelope calculations retirement savers often make. Mahabir says, “Most underestimate taxes on their Pension income and Social Security income.”

This underestimation may stem from a lack of understanding when it comes to the tax consequences of investing in a retirement plan versus a taxable account. “Very few people understand that their 401k’s and IRA’s/pension funds will be taxed at ordinary income tax rates when they retire even if they invest in the stock market or real estate through their retirement plans,” says Wheelwright. “While stock market investments made outside of a retirement plan are taxed at capital gains rates, if the investment is made inside a regular retirement plan, the income from the stock investments will be taxed at the higher ordinary income tax rates when the money is distributed to them at retirement.”

Things get more complicated at age seventy and a half. “Every investor expects to continue to pay income taxes during and throughout retirement,” says Ryan Brown, a partner and financial consultant at CR Myers & Associates in Southfield, Michigan. “The tricky part can be when an investor is unaware of the Required Minimum Distributions (RMDs) that the federal government forces you to withdraw from your qualified accounts (e.g., IRAs, 401(k)s, 403(b)s, TSPs, etc.). Any withdrawals from qualified accounts constitute taxable income. In the case of a hefty qualified account value, those RMDs can be tens of thousands of dollars. In those circumstances, it may also mean that the investor will be bumped into a higher tax bracket – in which case he or she may or may not be adequately prepared. Investors who have brokerage or investment accounts should also expect to pay some level of capital gains taxes, whether they be at the short-term threshold or long-term threshold.”

Comprehending the tax code is not an activity for the faint of heart and most retirement savers would faint if they saw the actual codebook. Smith says, “In my experience, most Americans do not have a detailed understanding of income taxes. People living on a fixed income (like retirees) need to pay particular attention to liquidating assets and portfolio decisions. These actions can lead to capital gains tax which can really impact seniors. We recommend engaging a tax professional and considering tax planning throughout the year so that seniors do not have a surprise on April 15th.”

The problem with current tax code is that it may not be the same in the future. This realization can have profound impact on the retirement savings strategy one undertakes. “We know the tax rates today, but not tomorrow,” says Anderson. “Clients usually have regretted having 100% of their retirement income taxed. Bottom-line: The planning you are doing today WILL impact you 20, 30, 40 years from now. You need pre and post retirement planning and it starts today. Don’t delay it…that will probably cost you more.”

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