One of the most common mistakes I see people make is overestimating their tax rate in retirement. This is important for a couple of reasons. First, as Roth 401(k) and 403(b) plans become more common, estimating your future tax rate is a big factor in deciding whether you should make Roth or pre-tax contributions. Second, your tax rate is used to estimate your after-tax retirement income in determining how much you need to save. Let’s take a look at some of the reasons why your tax rate in retirement may be lower than you think:

Your Income Will Probably Be Lower

Experts typically recommend that you need about 80% of your pre-retirement income in retirement, but depending on your situation, you may need even less. How much of your income goes to saving for retirement and paying into Social Security? Do you have a mortgage and other debts that will be paid off? Do you have kids that will no longer be financially dependent on you? How much do you spend on commuting and other work-related expenses?

Will you eat lunch out less often since you’re no longer at work during the day and have more time to prepare your own meals? Are you thinking of downsizing or moving to a lower cost area? When you add all this up, you may find that you need less than 80%.

Not All Your Retirement Income Is Taxable

When you’re working, the bulk of your income is from your job and is fully taxable (after deductions) at ordinary income tax rates. When you’re retired, this is only true for withdrawals from taxable retirement accounts and any pension, rental, business, and wage income you have. Social Security is also taxed at ordinary income rates, but only a max of 85% is taxable.

Withdrawals from Roth accounts are tax-free if you’ve had the account for at least 5 years and are over age 59 1/2. Accessing the principal from savings and investments is tax-free and long-term capital gains are taxed at lower rates or can even offset other taxes if you’re selling at a loss. (Gains on inherited investments are only taxed from the point that you inherited them.)

Your Effective Rate Is What Matters In Retirement

First, what do we even mean by “tax rate?” When you’re contributing to a retirement account, you probably want to look at your marginal tax rate. That’s the tax rate you pay on an additional dollar of income. The reason is because the next dollar that you contribute to your retirement account would normally be taxed at the marginal tax rate.

Let’s say I’m a single person with a taxable income of $50k a year. That puts me in the 22% marginal tax bracket. But according to this calculator, my effective tax rate would be less than 14% since only my taxable income over $40,125 or $9,875 would be taxed at that 22% rate. The rest would be taxed at 12% or less. However, if I contribute $9k to my 401(k) pre-tax, all of that $9k would normally be taxed at the 22% rate.

Now what happens when I take money out of my 401(k) in retirement? First some of my income won’t be taxed at all because of deductions. In fact, my standard deduction would be higher if I was age 65 or older this year.

The first $9,875 of taxable income would only be taxed at 10%. Then the next bucket of income up to $40,125 would be taxed at 12%. Only the income over $40,125 would be taxed at the 22% rate. Unless I’m retiring with a large pension (which is rare these days), the majority of those 401(k) withdrawals will be taxed at the lower rates.

You also want to use that lower effective rate when you’re estimating how much of your retirement income will go to taxes. Too many financial plans use the higher, marginal rate. While that’s a more conservative assumption that could motivate you to save more, it could also discourage someone from thinking that they could ever retire.

For example, a couple I recently spoke with didn’t think they would have enough income to retire. However, they were assuming that about 25% of their income would go to taxes. But when I used this tax calculator to estimate their federal and North Carolina state tax bill, it ended up being less than 14% of their income since Social Security was such a large percentage of their income and only half of it was taxable, in their situation.  Those 11 percentage points made a huge difference in their ability to retire.

You May Retire In A Lower Taxed State

Many states are very tax-friendly for retirees while some popular retirement destinations like Texas, Florida, and Nevada don’t even tax income at all. You can use this calculator if you’re curious how much you can save by retiring in a lower tax state. When you do the math, you’ll see that warm weather isn’t the only thing some of these states have going for them.

For all these reasons, you may be overestimating your taxes in retirement and hence underestimating your take-home retirement income. Fear of higher taxes in retirement could also bias you towards Roth rather than pre-tax retirement plan contributions. If you’re not sure how this could apply to you, consider consulting with an unbiased financial planner. You may even have free access to one through a workplace financial wellness program. In which case, taxes aren’t the only thing you may be spending less on!

source article: https://www.forbes.com/sites/financialfinesse/2020/05/26/4-reasons-your-taxes-in-retirement-may-be-lower-than-you-think/#4e31acd75e3c