Laylabird | E+ | Getty Images
Most Americans will have a lower tax burden in retirement than during their working years.
However, that may not be the case for some retirees, especially for higher earners and big savers, which could have a significant impact on their financial plans, according to financial advisors.
“Substantial evidence” suggests retirees have lower tax rates than during their working years, according to a 2024 paper published by the Center for Retirement Research at Boston College.
There are a few general reasons for this, according to a joint 2017 research paper by the Internal Revenue Service and Investment Company Institute: People who leave the workforce no longer pay payroll taxes. Their household income often drops, generally meaning less income is taxed. And Social Security recipients only pay tax on a portion of their benefits.
The “overwhelming majority” of people will have a lower tax rate in retirement, “hands down,” said Jeffrey Levine, a certified financial planner and certified public accountant based in St. Louis and chief planning officer at Buckingham Wealth Partners.
But that’s not always the case.
Required minimum distributions may be large
Those who’ve built up a sizable nest egg, perhaps with disciplined saving in a 401(k) plan or individual retirement accounts, may have large required minimum distributions, Levine said.
For example, the IRS requires that older investors take minimum withdrawals annually from “traditional” (i.e., pre-tax) retirement accounts when they reach a certain age. (It’s age 73 for those who turned 72 after Dec. 31, 2022.)
The total amount is based on an IRS formula. A bigger nest egg generally corresponds to a larger RMD.
This matters because RMDs from pre-tax accounts add to a household’s taxable income, thereby raising its total tax bill. By contrast, distributions from Roth accounts aren’t taxable, with some exceptions.
Investors held $11.4 trillion in traditional IRAs in 2023, about eight times more than the $1.4 trillion in Roth IRAs, according to the Investment Company Institute.
Additionally, investors who inherited a retirement account, perhaps from a parent, may have to empty the account within 10 years of the owner’s death, Levine said. Such withdrawals from a pre-tax account would further add to taxable income.
Retirees may not want to shrink their lifestyle
Aside from required withdrawals, big savers may choose to pull ample sums from their accounts to fund their retirement lifestyles, said Ted Jenkin, a certified financial planner based in Atlanta and the founder of oXYGen Financial.
In such cases, their taxable income may exceed that of their working years, said Jenkin, a member of the CNBC Financial Advisor Council.
“Most clients we sit down with today don’t want to see a diminished amount of income when they retire,” Jenkin said. “They still want to take the same level of trips, level of going out to concerts and dining, taking care of grandchildren, and many are still carrying a mortgage into retirement.”
In the first three to five years of retirement, Jenkin actually finds clients generally spend more than they do during their working years due to what he calls “a period of jubilation.”
“A lot of people just don’t want to shrink their lifestyle,” he said.
Consider your income tax assumptions
Investors should consider the income-tax assumptions they’re making for retirement — or ask their financial advisor what tax assumptions they’re making in clients’ financial plan, Jenkin said.
Such assumptions could have a big financial impact, akin to the difference between using a 3% versus 4% average inflation rate when modeling the relative success of a long-term financial plan, he said.
He advocates for planning conservatively. Planning for a tax rate that’s too low may raise the risk of running out of money in retirement, he explained.
“You always have to plan everything on an after-tax basis,” Jenkin said.
Of course, it’s impossible to determine future tax rates.
Congress may change the tax code, for example. To that point, there’s tax fight looming next year that could impact things like the size of the standard deduction and marginal income-tax rates.
That said, even if Congress were to increase the marginal income-tax brackets in the future, most retirees would likely still see their “personal tax rates” fall versus their working years, Levine said.