Many Americans assume they’re paying higher taxes now than they will in retirement. But what if that assumption turns out to be false?
Income taxes don’t go away in retirement. By structuring their taxes to minimize their burden today rather than in retirement, many Americans are raising the incline in an already uphill battle to save enough to live on when they’re no longer working.
As you form your retirement and financial independence plan, beware of the risk posed by income taxes. With the right planning now, you can minimize both your tax burden and your required nest egg for retirement.
Why Your Tax Bill Might Go Up in Retirement
Today’s tax rates aren’t written in stone. And there are many reasons to believe they’ll go up in the not-too-distant future.
Before you get too cozy with the idea of minimizing your taxes today at the expense of tomorrow, remember that tax rates change, and the U.S. faces significant economic and demographic challenges in the decades to come.
Even if tax rates remain frozen in place, your situation will change. So you need to plan not based on your current wealth but your future wealth.
Current Tax Rates Expire in 2025
The current federal tax rates, set by the Tax Cuts and Jobs Act of 2017, expire in 2025 unless Congress extends them.
Among other changes, the law nearly doubled the standard deduction from its previous high of $6,500 to $12,000 for individuals and $24,000 for families. And that was in 2017 — it’s continued to rise since.
A high standard deduction simplifies many middle-income earners’ returns by negating the need to itemize their deductions and helps reduce their taxable income.
The law also reduced the tax rates for most income brackets. For example, a single earner with $50,000 in annual income previously paid the IRS a top tax rate of 25% but today pays 22%.
That won’t last forever. And it’s hard to imagine tax rates dropping lower than they currently are.
Today’s Historically Low Tax Rates
Consider the historical context for federal income taxes. The maximum federal income tax rate today is 37%. In 1944, the top federal income tax rate was a dizzying 94% for anyone earning over $200,000. It only took an income of $8,000 to be taxed at the 37% level.
Even accounting for inflation, that was a high middle-class income — around $115,000 in today’s dollars. And someone earning the equivalent of today’s median income paid taxes at the 29% rate compared to today’s 22%.
After World War II, middle-income households continued paying relatively high rates. The highest federal income tax rate remained high in the ’50s, ’60s, and ’70s, never dropping below 70%. Tax rates changed dramatically in the ’80s under President Ronald Reagan, and they have remained relatively low in the decades since.
Don’t expect that to last either.
Ballooning Budget Deficit
In September 2020, the Congressional Budget Office projected an annual budget deficit — the difference between how much the federal government spends compared to how much they collect in revenue — of $3.3 trillion. That’s $3,300,000,000,000 for numerical context, and a record.
As of early 2021, the U.S. national debt has exploded to $27.9 trillion for the first time. That comes out to $194,696 per taxpayer.
In short, the U.S. government faces record debt, and they must eventually pay the piper. And “they” means “you,” the taxpayer, in the form of higher taxes.
America is graying. By 2030, the entire baby-boom generation will be over 65, according to the U.S. Census Bureau. That means that 1 in 5 Americans will be at retirement age.
The bureau also notes that by 2035, there will be more seniors at retirement age than children under 18 due to declining birth rates. Already, native-born Americans have a negative birth rate — in other words, the average number of children per woman falls below the population replacement rate.
In fact, 2018 marked the lowest birth rate in more than 30 years, per the CDC. The only reason the U.S. population continues to grow at all is immigration.
As of 2021, there will be three and a half working-age adults for every retirement-age adult — an already low ratio. Over the following 40 years, the bureau expects that to drop to two and a half working-age adults for each senior.
That means fewer workers to support more benefit recipients.
Entitlement Spending Increases
The 2020 Social Security Trustees report paints a grim picture.
In 2020, costs exceeded revenues for the first time since 1982. The government will deplete the reserve fund by 2035 based on current spending and revenue trends.
The numbers look even worse for Medicare. Claims will deplete Medicare’s hospital insurance fund by 2026, according to current projections.
All of this suggests tax hikes are on the horizon. Cutting spending on these entitlement programs remains politically unfeasible given the powerful senior lobby, and commonsense solutions to Social Security’s solvency problems may well go unheeded.
Don’t count on receiving the same kind of Social Security benefits in retirement that your parents pocketed.
Increased Personal Wealth in Retirement — Hopefully
The final reason you’re likely to face higher taxes in retirement has nothing to do with macroeconomics or the political landscape. The simple fact is you’ll be wealthier by the time you retire, at least if you continue to save for retirement diligently.
One of the ways retirement has changed over the last few decades is that you’re increasingly responsible for saving, investing, and planning for your own retirement. You save up a nest egg, you build passive income streams, and then you live on them happily ever after.
And you pay taxes on them too.
How to Prevent Higher Taxes in Retirement
Retirees have no control over the federal tax rate, short of voting for a rare candidate who might actually curb spending and reduce the federal budget deficit.
But you do have control over structuring your retirement savings and income for minimal taxes.
Try these seven tactics to reduce your tax burden in retirement, which in turn reduces how much you need to save for retirement to create the same net income for living.
1. Roth Conversion
When you invest in a traditional IRA instead of a Roth IRA, you get the tax break this year but pay taxes later. You deduct the contribution from your taxable income now, but the government taxes the earnings and eventual withdrawals later.
The opposite is true for Roth IRAs. You don’t get the tax deduction right now, but your earnings and withdrawals are tax-free.
One easy step is to start contributing to a Roth IRA rather than a traditional IRA. This can easily be done through brokers like SoFi. You can do the same with a Roth 401(k) rather than contributing to a traditional 401(k).
You can take it a step further by moving money from your traditional IRA into your Roth IRA. It’s called a Roth conversion, and it requires you to pay taxes on the moved money now. But the money then starts growing tax-free. In retirement, you benefit from tax-free income.
To prevent a massive uptick in taxes now, consider gradually transferring your IRA funds over several years.
For example, if you’re a single filer with $70,000 in taxable income, you can transfer $14,000 in a Roth conversion this year, which prevents any of your income from crossing into the 32% tax bracket. In the following years, you can move more money over each year until you’ve converted your entire traditional IRA account into your Roth IRA.
It especially makes sense if you’re thinking about moving from a low-tax state to a high-tax state. Bite the tax bullet now before your new state starts charging you higher income taxes.
Note that you can also invest in Roth versions of your employee retirement plan, such as your 401(k) or 403(b). As an added bonus, Roth accounts give you more flexibility, with no required minimum distributions.
Pro tip: If you’re currently investing in an IRA or 401(k), make sure you sign up for a free analysis from Blooom. They look at your portfolio to make sure you have the right amount of diversification and proper asset allocation based on your risk tolerance. They also make sure you’re not paying too much in fees.
2. Move to a Lower-Tax State
Seven states charge no income taxes whatsoever: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Another two states — New Hampshire and Tennessee — don’t charge income tax on earned income but do charge taxes on investment income, such as dividends and interest.
State income taxes aren’t trivial. In California, for example, the top income tax is 12.3%. And it’s not just high earners who are slapped with high taxes, either. A person earning the median U.S. income of $61,372 still pays 9.3% of it in state income taxes to California, which comes to nearly $6,100.
Most people can think of a few things they’d rather do with $6,100 every year. Just imagine how much sooner you could retire if you invested an extra $6,100 every year.
Of course, income taxes don’t tell the whole story. States also impose property taxes, sales taxes, and excise taxes, so when evaluating lower-tax states, look at the states with the lowest total tax burden.
3. Move Abroad
When you live abroad, the first $105,900 you earn is tax-free, per the foreign earned income exclusion.
Granted, you still have to pay self-employment taxes if you own a small business or are self-employed. But you avoid federal and state income taxes, at least on the first $108,700 for tax year 2021. It’s how I minimize my own tax burden.
The financial perks don’t end there. Most countries have a lower cost of living than the U.S., and many have weaker currencies to boot, so your dollar stretches much further. In many countries, you can live a relatively luxurious lifestyle for $2,000 per month.
Moving abroad, even temporarily, has simply never occurred to most Americans. But moving to another country was one of the best financial moves my wife and I ever made. We benefit from a lower cost of living, affordable (and high-quality) health care, and lower taxes.
In many countries, you don’t even need a job to move there. You can buy residency or citizenship to set up shop permanently.
4. Use an HSA as a Stealth Retirement Account
More Americans are discovering health savings accounts (HSAs) offer better tax benefits than any other tax-sheltered accounts.
Unlike IRAs and Roth IRAs, HSAs offer tax protection both now and later. You can deduct contributions from your taxable income this year, they grow tax-free, and the withdrawals are also tax-free — for triple tax protection.
Yes, you have to use the funds for health-related expenses. But that’s a wide umbrella, including not just doctor’s visits and medications but also glasses, contacts, dentist appointments, birth control, acupuncture, therapy, and even home improvements to help you age in place safely.
Besides, you’ll have plenty of health care expenses in retirement. The average couple spends over $285,000 on medical expenses after the age of 65, per a Fidelity report. So why not cover those expenses with your HSA funds and reap the tax benefits?
5. Optimize Your Dividends & Capital Gains
You have many tools at your disposal to avoid paying taxes on dividends. For example, below a certain income level — $80,800 for married couples in 2021, $40,400 for individuals — qualifying dividends aren’t taxed at all.
Likewise, you can also minimize your capital gains tax through a range of tricks and strategies. Holding an asset for at least a year reduces the tax rate from your regular income tax rate to the far lower capital gains rate. Even that you can sometimes avoid. For example, if you lived in a property for at least two of the last five years before selling, your first $500,000 in gains are tax-free if you’re married and $250,000 if you’re single.
The rules can get arcane and complex quickly, so talk through your tax strategy with a financial advisor if you have any doubts about how to move forward. If you don’t currently have a financial advisor, SmartAsset has a tool that will help you find a vetted advisor near you.
6. Consider Municipal Bonds in Retirement
As workers near retirement, conventional wisdom suggests they gradually shift their asset allocation to include more bonds, given their lower volatility and income-oriented returns.
And if you’re going to invest in bonds, why not save on taxes by including some municipal bonds?
Returns on municipal bonds are typically exempt from federal income taxes and often from state and local taxes as well. However, you often have to invest in local municipal bonds for your state and municipality to exempt the earnings from taxes.
After maxing out your annual tax-sheltered retirement account contributions, consider municipal bonds as another way to invest tax-free.
7. Harvest Losses
Even after retiring, don’t be afraid to harvest losses in your brokerage account to offset gains. Most robo-advisors, like Betterment, automatically provide tax-loss harvesting on your account throughout the year.
Imagine your investments have a strong year and earn enough in taxable gains to enter you into a higher tax bracket. You also have a few investments that have consistently underperformed for you that you’ve meant to sell off and reinvest elsewhere. That can be the perfect time to take those losses and move on as a year-end tax maneuver.
Just be careful not to sell fundamentally sound investments. Think of tax-loss harvesting as a way to clean out the deadwood in your portfolio. But avoid selling only for the tax benefits — only sell investments you truly no longer want.
Far too many investors falsely assume their taxes will be lower in retirement. But just because you’re no longer earning a W-2 paycheck doesn’t mean you won’t pay taxes.
You still earn taxable income from Social Security, from your brokerage account and investments, from part-time gigs, and perhaps from a pension. And hopefully, you’ll be significantly wealthier by the time you retire as well.
Start laying the groundwork now for lower taxes in retirement. Capitalize on tax-sheltered accounts that let your investments grow and compound tax-free, such as Roth IRAs and health savings accounts. Talk to your financial advisor about other ways you can structure your investments to minimize your tax burden in retirement.
Because the less retirement income gets siphoned off to taxes, the less you need to save for retirement, and the earlier you can consider retiring.