Uncle Sam Wants YOU… to Retire?

When I meet with investors, most believe health care will be their single largest expense during retirement. They’re surprised when I tell them if I were a betting man I’d bet that taxes will be.

Yes, the T-word—everyone’s favorite topic. In fact, taxes are the single largest expense for many working people, especially when you factor in property taxes from home ownership in addition to federal income taxes, state income taxes (where applicable), and Social Security and Medicare taxes.

I find most investors never grow accustomed to thinking about taxes as a household expense item, because taxes are silently deducted from paychecks throughout the year. This thinking is especially common among folks who are used to getting a refund at tax season and feeling like some bonus income just came their way — instead of realizing the government had interest-free use of money they didn’t owe.

When you hit retirement, however, you quickly notice how large your tax expense is because you, rather than your employer, are writing the tax checks to the government. Here we’ll take a closer look at why taxes will be such a significant problem for many retired investors, and then discuss one potential solution to ease that burden if you’re still a few years from retirement.

Tax-Deferred Accounts Create Big Tax Liabilities in Retirement

The primary reason taxes will be the single largest expense item for so many retirees is that many Americans now have the bulk of their retirement money in tax-deferred accounts. Unfortunately, very few of those investors realize how much of those accounts will be lost to taxes.

First, what is a tax-deferred account? Classic examples are a 401(k) or traditional IRA. In a tax-deferred account, the money grows without incurring taxes along the way, regardless of how many times you buy or sell investments in that account, but . . . once you begin withdrawing the money, every single dollar is taxed at your ordinary income tax rate. It’s important for investors to realize a withdrawal from a tax-deferred account equals taxable income.

One of the first questions I ask folks when I do presentations on this topic is how many people in the room have done an estimate of where their tax bracket is going to fall in retirement versus where it falls today. Typically the room gives me a blank stare, or perhaps one hand will go up.

This is a critical question that must be estimated as part of prudent retirement planning. Some people tell me it’s impossible to estimate with accuracy because of various unknowns about retirement expenses, rates of return, and how tax rates may change.

I like to borrow one of Warren Buffett’s one-liners in response: “I’d rather be approximately right than precisely wrong.” By not doing an estimate, you’ve chosen to be precisely wrong. Let’s go through an example.

You Could Lose More Than 25% of Your 401(k) to Taxes During Retirement

Suppose you and your spouse both have 401(k) accounts that have grown to $500,000 at the time you retire ($1,000,000 in total). Suppose further you are drawing Social Security and working on a part-time basis as you ease into retirement, and need to withdraw $50,000 per year in total from your 401(k) accounts to support your lifestyle.

Because of the way marginal tax brackets work, those withdrawals will often be taxed at a higher rate than the rest of your income. In fact, it’s very conceivable that some or all of your 401(k) withdrawals will be taxed in the 25% federal tax bracket.

Why? For married couples filing jointly, the 25% federal bracket represents taxable income between $74,900 and $151,200 in 2015. So if your combined Social Security checks and part-time incomes add up to $75,000 a year, any additional income — such as your IRA or 401(k) withdrawals — will be taxed at the 25% rate or more.

(Note that if your only income is the average Social Security payout of $26,000 a year for a retired couple, most or all of that $50,000 withdrawal will fall into the more benign 15% tax bracket — it’s only income above $74,900 that gets hit with the higher rate. If you’re confused about how tax brackets work, read this primer.)

The bottom line is your $500,000 401(k) account is not worth $500,000 to you. After a 25% haircut as you make withdrawals, federal taxes may wipe out $125,000 of the account value, leaving you with only $375,000 in your pocket.

(By the way, many middle-income investors are also rudely awakened to learn that up to 85% of their Social Security earnings may be considered taxable income — but that’s another topic for another day.)

But wait . . . unfortunately it gets even worse for some of us.

All but seven states also impose a state income tax, and the states have not received their tax share of this 401(k) money yet. I happen to live in Wisconsin where many middle-income retirees will pay another 6% in taxes on these withdrawals. That’s another $30,000 haircut on a $500,000 account, potentially leaving a retired Wisconsinite with only $345,000 for their consumption after federal and state taxes. You will need to understand the tax structure in your particular state.

Before we shed some light on this depressing problem, let’s first go even further into the dark side and examine another issue that will affect tax-deferred accounts: predicting what tax rates are going to do in the future.

Do You Believe Future Tax Rates Will Go Higher or Lower?

I haven’t met a person yet that believes tax rates will be lower 10 years from now than they are today. And for good reason. As Americans we tend to be poor historians, but historically speaking, we are in a very low-tax environment today when compared to the past 100 years.

The top federal tax rate today is 39.6%, with most middle-income Americans falling in the 25% bracket or below. To find dramatically higher rates, we only need to look back to the mid-1980s, when the top federal tax rate was 50%, or to the early 1980s, when it went all the way up to 70%, or to the 1960s, when the top federal tax rates went all the way north of 90%!

We all know that federal budget deficits in the hundreds of billions or trillions of dollars are unsustainable. Spain and now Greece have provided us a roadmap in recent years of what the outcome looks like if we do not get our deficits and debts under control.

We also know that mandatory federal spending on Social Security, Medicare and Medicaid, and interest on the federal debt will be increasing at a rate of more than 7% per year over the next 10 years, from just under $2 trillion in 2014 to more than $4 trillion by 2025 (see the Congressional Budget Office’s January 2015 baseline report). I also personally believe the CBO is underestimating what could happen to the interest on the federal debt.

The only way to close the gap on these ballooning mandatory obligations is to increase tax revenues. (I suppose technically the government can also cut Social Security and Medicare/Medicaid benefits, but that would essentially have the same effect as a tax increase on retirees and would also likely get many politicians voted out of office. I suspect they will increase taxes on the entire population first before targeting benefit cuts for one of the largest voting blocs.)

Tax revenues can be increased either by raising tax rates or by broadening the wage base on which taxes are levied. If you’ve been following the news the past several years, you know that wages are not increasing anywhere near that 7% annual level that mandatory federal spending is projected to increase. That leaves increasing federal tax rates as a likely option.

And don’t forget about state tax rates—those could very well increase too. Wisconsin just faced a more than $2 billion budget deficit in its biennial budget this year. This time around it was balanced through spending cuts. Next time around it could be an increase in taxes. Other states all around the country are in the same boat.

The bottom line is the data are telling us 25% of a middle-class American’s 401(k) is likely going to be eaten by federal taxes, and an additional piece of the pie will be eaten by state taxes in the 43 states that impose them. Plus, there’s a reasonable probability that federal and/or state tax rates will have to increase during the next 10 to 15 years.

This is depressing news, but it’s important to get a dose of reality before it actually hits. And the great news is there are actions you can take to counteract this problem. I am only going to focus on one today. This particular solution is primarily for those of you who are still working. So, what is it?

You Can Convert Tax-Deferred Money to Tax-Free Money Now

You should consider converting a portion of your portfolio from tax-deferred status to tax-free status via a process called a Roth conversion.

A Roth conversion is when you convert a tax-deferred account, such as a traditional IRA, into a Roth IRA, which is then tax-free from that point forward. The kicker is you pay taxes on the money in the year you convert the account — but once the conversion is complete, the money is tax-free the rest of your life.

Roth conversions used to be off limits to a large number of investors due to income limits. However, those restrictions were lifted in the past few years, making this option available to millions of investors previously prohibited by the income limits.

Reasons to Consider a Roth IRA Conversion

What are some reasons you should consider doing a conversion now? First, as we discussed above, income tax rates are at historical lows. If you fall in the 15% bracket or even the 25% or 28% brackets, you should consider what amounts to locking in those historically low tax rates now.

Second, as we also discussed above, there is a reasonable probability the federal government and/or your state government will need to increase taxes before or during your retirement, which leaves all of your tax-deferred money susceptible to significant tax increases in the future. By converting to a tax-free Roth IRA now, you replace an unpredictable tax future with a known tax bill today.

Third, you will likely have fewer tax deductions during retirement than you do now — which could leave you in a higher tax bracket than you expect during retirement. For example, retirees typically no longer have deductions for children, mortgage interest, or business expenses they once had during their working years.

Fourth, and perhaps most importantly, you can pay the taxes from your current earnings without draining your retirement account, and therefore preserve the retirement money you have saved. After you stop working and need to pay a tax bill on a withdrawal from a tax-deferred account, where is the money going to come from to pay the tax? It will likely come from further withdrawals from your retirement savings or from your Social Security income, both of which you had planned to use to support your retirement, not to be allocated to tax bills.

Reasons Not to Do a Roth Conversion

To be clear, I am not trying to force this strategy on anyone. I am merely trying to get you to think about some tax issues that you may have been entirely unaware of.

Let’s look at the other side of the coin. What are some reasons you may not want to do any Roth conversions?

First, if you need this money in the next five years, then a Roth conversion is not a good option. You face a withdrawal penalty for any withdrawals made within the first five years after the conversion.

Second, if the five-year waiting period for this portion of your money is not a problem, then it boils down to whether you are confident your tax rates while taking withdrawals during retirement will be lower than your tax rates today. That will depend on two things:

  1. your current income vs. your income and withdrawals during retirement (remember, withdrawals from tax-deferred accounts are considered income), and
  2. whether federal and state tax rates during your retirement stay the same or change.

The second factor is unpredictable, but you should absolutely sit down and try to estimate the first factor with your tax advisor.

Consider Hedging Some of Your Risk

The bottom line is, the future is unpredictable — so why not hedge a portion of your tax risk and convert part of your tax-deferred portfolio?

You are not required to do an all-or-nothing conversion. You can convert only a portion of a tax-deferred account. That way you can create an ample source of tax-free funds to withdraw from during retirement, in addition to your tax-deferred funds, and can regulate the amount of your tax-deferred withdrawals to keep yourself in the lowest tax bracket possible.

Either way, most investors need to give the tax issue a lot more thought than they currently do. Taxes are a large enough expense category already — you don’t want them to become an even larger surprise when you’re trying to enjoy the golden years of your life.

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Tim Van Pelt is a financial planner. You can reach him at tjvanpelt@gmail.com or (608) 577-9877. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, investing, tax, legal, or accounting advice. You should consult your own investment, tax, legal, and accounting advisors before engaging in any transaction.