Retirement

Why You’re Likely To Be In A Higher Tax Bracket When You Retire

June 11, 2007 By Teri Newton 7 Comments

Something has been bugging me about IRAs lately. Most of the time I read an article or discussion about Traditional IRAs, as opposed to ROTH IRAs, I see that it is a pretty common assumption that income tax rates will be lower when one retires. Every time I see any mention of tax rates most definitely being lower in retirement I cringe. This appears to be the most commonly mentioned benefit of a Traditional IRA over a ROTH IRA, but to me it just doesn’t make any sense. For many of us the odds are that our income tax rate will actually be higher in retirement. Here are the reasons why:

Income Tax Rates are at Historic Lows

Before the Bush Tax Cuts my spouse and I both worked and we paid some hefty taxes, save for our large mortgage, living in an expensive area. Since the Bush Tax Cuts we went down to one income and had children. Our income taxes have gone from 25% of our income to an average of 0-5% over the last few years. There are a multitude of reasons why: large child tax credits, removal of marriage penalty in the tiered income tax rates, favorable treatment for investment gains, etc. We make more money but we get to keep most of it because we have a mortgage and a couple of kids. We’re just a typical middle class family and the government is running up quite a lot of debt. It only seems logical that our income taxes will have to go up in the long run.

This website shows historic tax rates in the US since 1945. As recent as 1979, the top income tax rate was 70%. (Today it is 35%). Interestingly, it was generally thought in the 1970s that income tax rates would rise more. Instead they have fallen significantly. Predicting future tax rates is most certainly a risky business.

Odds are You’ll be Single in Retirement

I have a lot of retired clients and a large number of them are single. Not that many planned to be single in retirement, but many of them are widowed. When you are single, you get fewer tax deductions. For now you also get less favorable income tax rates when you are single. For example, if you are single and make $30k then you are in the same tax bracket as a married couple making $60k. However, when you hit retirement, your income is usually pretty steady whether you are married or single. If your spouse passes away and you continue to draw on retirement at the same pace, you could be taxed more for the same money.

Historically the income tax rates were not so favorable to married taxpayers (part of the old “marriage penalty”) and so who knows if the income tax rate structure will stand for the long haul. This really could be a moot point. For now, when you are married you do get more deductions when you file your tax return than single tax filers. This is just something that I see a lot that most people don’t think about when they are planning their retirement in 20-40 years.

You Could Make More Money in Retirement

Most people don’t really consider the possibility that they will make more money in retirement. There will be a lot of factors here, but if you are young in your career you have to realize that you shouldn’t be anywhere near your full income potential. When you are young the odds are that you will be making much more money as you near retirement and that you will also expect much of that increased income in retirement. You could also become accustomed to that lifestyle and want to maintain it in retirement.

I think that most of us expect to, and probably will, cut back our lifestyle a bit as we near retirement. However, if a certain level of comfort is necessary to you in retirement, keep in mind that you could be pulling the same income in retirement as before. It does happen, and careful planning should mean you don’t have to diminish your lifestyle just because you retire. If you expect to make more income in retirement than today, I think it is reasonable to assume your tax rates will be higher as well.

You Will Lose Most Tax Deductions and Tax Breaks in Retirement

I don’t know why I have noticed this particularly this year, but when preparing tax returns most of the six-figured, young middle class families (clients) were in the 15% tax bracket, whereas all my retired clients seemed a little extra stressed this year with their income tax situation. They all came begging to me for some tax-savings strategies. The thing that most people don’t realize is you have it pretty good when you are young, but when most of your income is investments in particular, there is not much you can do to shelter the income from taxes. When you are retired you are not going to be allowed to put money into retirement for a tax break. When you are retired you are not going to have a mortgage deduction most likely, and you are not going to have all the tax breaks that come with having kids.

On average most of my retiree clients had much less income than their younger working counterparts, but they also had higher income tax bills. Their marginal tax rates were on average the same or higher as young families with 2 or 3 times as much income, and their effective tax rates (total tax divided by total income) were higher as well.

The only exceptions were the young professional singles who were bringing in well over six figures. Of course, they are so far on the road to success making that kind of money so young that I would not be surprised if they paid more taxes in retirement as well, as they should be able to build up significant nest eggs.

Even the retirees I saw making $20k/year had higher effective tax rates than some of the young families making three times as much.

I am not entirely convinced that putting all your eggs in one retirement tax strategy is the way to go, so I want to be clear that I am not saying ROTH IRAs are the obvious winner. I actually have a lot of reasons why I would avoid a ROTH. Taking a tax break today with a Traditional IRA is a sure thing, where as betting on future tax rates will always carry some risk. However, if you choose a Traditional IRA or you choose to put much more money in your 401k than your ROTH simply because you hear it is a given that your income taxes will go down in retirement, it may be time to rethink that strategy. In the meantime, I mostly recommend doing a little bit of both if you can. I wouldn’t put all my eggs in one basket with so many future unknowns.

(Photo courtesy of Roberto.Jorge)

What If Someone Won’t Spend Money? (Your Advice)

June 8, 2007 By Jeffrey Strain 14 Comments

It’s not often when I receive an e-mail about personal finance that is quite different from the majority that I have received before. That was the case with this e-mail which came in from a reader about what she should do with her husband and money:

I have a problem. To most people it doesn’t seem like a problem. They think that we have nothing to worry about regarding money so I should not complain. I’m hoping that you can help me. What do you do when your husband refuses to spend money?

We have saved money all our lives and are retired. We have over $1.5 million in retirement accounts, our mortgage is completely paid off and we have no other debts, plus we have a substantial amount of money in regular savings account. We always made by on a little less than we wanted to in order to achieve this nest egg for our retirement years.

The problem that I have is that now that we are here, my husband refuses to spend any of the money that we have saved. When we go on trips, he always insists that we stay at the most inexpensive hotels like Motel 6. Last year for his birthday, I booked us a nice dinner cruise on the Bay which was lovely except for the fact that he complained that it must of been too expensive the entire evening.

I thought we had saved so that now that we both have free time we could spend the money on all the things that we dreamed of doing, but he seems to think that we need to continue saving money as best we can. How do you convince somebody who has saved all their lives that it’s okay to spend a little money on themselves now and then? Every time I suggest that we spend a little bit of our money on something exciting, he says that we need to save a little bit more before we can afford it which just isn’t true.

I’ve tried rationalizing with him and telling him this is exactly why we had saved the money all those years, but it doesn’t seem to be getting through his head. How do you convince somebody that it’s okay to spend money and have a little fun and extravagance from time to time?

If you are in a similar situation and had a partner that refused to spend the money that you had saved together over your lifetime, what steps would you take to solve the problem?

What To Do With Retirement Funds After Retirement? (Your Advice)

June 1, 2007 By Jeffrey Strain 4 Comments

When it’s time to leave a job you have more than the loss of income to think about in regard to your personal finances. You also need decide what you will do with the accumulated money in retirement plans at the company. That is a question that this reader has:

My wife will be retiring from a large company in another 4 years or so where she has done well. Her 401k retirement fund at the company is about $600K with an additional $300K in the company “matching” stock plan for a total fund of $900k.

My question is what steps do we need to take so that we don’t have to pay a fortune in taxes when she retires? Is it possible to transfer the retirement money into a stock plan without having to pay a large amount in taxes?

I know we have to pay taxes if we withdraw from the retirement fund for our personal use, but will we have to pay if we want to keep the money invested? I’m sorry this is such a basic question, but we’re not at all financially literate and are not sure what to do.

What would your recommendation be on what this couple does with their retirement funds and in what type of investments would you place them?

On The Right Financial Road? (Your Advice)

May 11, 2007 By Jeffrey Strain 7 Comments

When you make financial decisions, there are times when you’d like to have others take a look at the decisions you have made and give their honest opinion on whether or not they think you’re on the right track. That is exactly what the writer of this email was looking for:

I earn approximately $77k and my wife is a stay-at-home mom. We carry no credit card debt. We have a 3 year old and a four month old. We have about $70,000 in 401(k) savings and between 3-6 months in liquid savings. We currently contribute about 4% of our income to retirement savings which maximizes my company match. We have about 5-10% equity in a $205,000 home and are aggressively overpaying both our 80% first mortgage (a 5.75 30-year) and our 20% HELOC (prime + .5) second mortgage. We have about $90,000 in federal student loans (85% is mine) debt at relatively low, fixed-rates (and consolidated). After the modest 401 contribution and the mortgage overpayment (about $8500 a year) we don’t really add anything to savings.

Conventional advice often seems to suggest we focus on retirement savings versus things like 529 plans or even aggressive mortgage overpayment. Since we originally put nothing down on our mortgage (and because I want to maximize our ownership stake for my wife’s benefit if I were to die suddenly; I have a $1m term life policy), we have been focused on building equity in our home but less on retirement savings (only that 4% or so). As far as those mortgage over payments, we have been overpaying both mortgages with the logic that the lower rate 30yr has a much higher balance, and the variable HELOC rate has a much lower balance, but we still expect to sell within 2-3 years. I am almost 34 and my wife is 35.

What do you think of the way we are tackling our finances, given goals of increasing net worth, potentially funding college education, retiring at some point, etc. My wife will likely return to work at least part time when our kids are in school in a few years.

Do you believe he on the right financial path given his goals or would you recommend that he make some changes in his financial plan?

Financial Laziness

March 27, 2007 By Jeffrey Strain 6 Comments

A lot of problems with finances are the direct result of being financially lazy. That is, you know what you should be doing, but you’re just too lazy (or have a convenient excuse) not to do it. And while life is certainly not about making sure every detail of your finances is perfect 24 / 7, most financial laziness comes in the form of financial leaks that could be solved with a small amount of time and effort. Here are 10 signs that you may be financially lazy:

1. You don’t pay off your credit card in full each month.
2. You pay banking fees.
3. You still have your savings in a brick-and-mortar bank.
4. You don’t compare your insurance rates once a year.
5. You have more than an occasional ATM fee.
6. Your phone service is over or under utilized.
7. You have subscriptions you don’t use.
8. You’re not contributing to an IRA.
9. You don’t contribute the full 401(k) match your company offers.
10. You haven’t done your taxes yet.

While this is certainly not an exhaustive list of where you can become financially lazy, it’s a good starting point to take a look at where you might be able to improve your finances. Financial laziness happens to the best of us and it’s good to get a reminder every once in awhile to get off your butt and do the things you know you should be doing.

Why Contribute To Retirement Savings (video)

February 3, 2007 By Jeffrey Strain Leave a Comment

Here’s an interesting interview that is well worth watching just in case you need any more incentive to contribute as much as possible to your retirement plans. The interview is with Andy Eschtruth from the Center for Retirement Research at Boston College.

See Video Here

One fact I found interesting was that most low and middle income earners rely on Social Security as their main source of income once they retire.