Of course, the answer to this question is “it depends”. To answer this question, we would need to determine what type of income or cash flow is being used to fund your retirement. Income that is taxable includes, but is not limited to, the following types of income:
1) Wages, salaries, bonuses
2) Interest and dividends
3) Pension and annuity distributions
4) 401(k) distributions
5) Traditional IRA distributions
6) Social Security (above base amount)
In addition, the amount of tax we would owe in retirement depends on our income level, tax bracket and the corresponding tax rates for those tax brackets.
As you approach retirement, you may be saying to yourself, “I will spend less when I retire so therefore my taxes will also go down”. If that is what you’re banking on, you may be disappointed when you determine your actual tax liability during retirement.
If we are drawing on funds from our 401(k) or income from a part-time job to fund our retirement, we will be taxed on proceeds if the amount for the taxable year exceeds a certain amount as determined by federal tax laws.
The amount of taxes you pay is not driven by how much you spend. Instead, the amount of taxes you pay hinges on how much you receive as income as defined by the Internal Revenue Code. Your withdrawals will be taxed at current tax rates during the year you take your withdrawals, not at the tax rates that were in effect when you earned your income.
Generally speaking, as people enter their retirement years, they will have paid off their home and their children have reached adulthood. That’s both the good news and bad news. The good news is that they now own their home free and clear and their children will ideally be financially self- sufficient. The bad news is that they have no longer have their mortgage interest to deduct on their taxes and even if their adult children are living with them, there will no longer be exemptions for children living with them (effective tax year 2019). Therefore, the retiree will have lost essential tools to reduce their tax bill.
Some people might argue that the only income they expect or need to draw on is Social Security and do not expect to be taxed on this income. The reality is that they may have to pay taxes if their combined income including Social Security, is above a certain limit (the IRS defines this limit the “base amount”).
Another factor to consider is who or what determines federal tax rates? Our first clue to the answer is that the taxpayer does not have the power to determine tax rates. The rates are determined by Congress and then signed into law by the President.
We must also factor in the macroeconomic environment we are living in. The country is currently running a 30 trillion-dollar deficit with $200T in unfunded liabilities (Social Security, pensions, etc.).
Our economy and geopolitical environment are undergoing massive and volatile changes. The U.S is already seeing major demographic shifts as the largest generation, the Baby Boomers, retire at the rate of 10,000 people a day. To support these retirees through Social Security, enough of the current workforce must pay into Social Security. Due to the lackluster and unstable job market for the generations coming after the Baby Boomers, the ability of the current workforce to support current retirees’ Social Security is substantially impacted.
It is important to note that the 3 main sources of revenue for the government to meet these obligations are: 1) individual income taxes, 2) payroll taxes and 3) corporate income taxes. In light of these looming macroeconomic changes and the country’s current economic position, which direction do you expect tax rates to head and how do you think it will affect your taxes?
So, to answer the question “will I really pay lower taxes when I retire?”, it depends on whether you have a plan and know how to position your money to minimize the tax impact. With the proper type of planning and adequate time to prepare for retirement (ideally more than 10 years) along with the guidance of an advisor at QX, you can position yourself to adeptly navigate the treacherous tax waters, no matter what happens in the economy and geopolitical environment.