Taxes in Retirement: The Expense Nobody Knows Exactly

Most people spend decades planning for retirement.

They estimate how much they'll need. They build an investment portfolio. They think about Social Security. They may buy a home, pay off debt and accumulate a substantial retirement account.

But there is one retirement expense that is almost impossible to predict with certainty:

Taxes.

We know taxes will exist.

What we don't know is exactly what the tax code will look like 10, 20 or 30 years from now.

And for retirees with substantial assets, that uncertainty deserves a place in the retirement plan.

Your Retirement Income Isn't Necessarily Tax-Free

One of the biggest misconceptions about retirement is that your tax bill somehow disappears when your paycheck does.

It doesn't.

Traditional 401(k)s and IRAs generally provide tax deferral rather than tax elimination. When you eventually take distributions, those distributions are generally included in taxable income. (irs.gov)

Interest, dividends and capital gains in taxable accounts can have their own tax consequences.

Social Security can also become partially taxable depending on your overall income. (ssa.gov)

And eventually, required minimum distributions can force money out of certain retirement accounts whether you actually need the income or not. Most traditional retirement accounts are subject to RMD rules beginning at age 73 under current law. (irs.gov)

So retirement isn't necessarily the end of your relationship with the IRS.

For some retirees, it can be the beginning of a much more complicated one.

The Problem With Planning Around Today's Tax Code

The tax code you retire under may not be the tax code you die under.

That's not necessarily a prediction that taxes are going up.

They could.

They could stay roughly where they are.

Certain rates could fall while others rise.

Congress could change deductions, credits, thresholds, exemptions or the treatment of particular types of income.

That's the problem.

We don't know.

And that uncertainty makes retirement planning different from simply calculating a retirement number.

If you retire at 65 and expect to live into your 90s, you're potentially planning across multiple decades of tax policy.

The goal shouldn't be to predict exactly what Congress will do.

The goal should be to build enough flexibility into your financial plan that you're not completely dependent on one particular tax environment.

Tax Diversification

Most people understand investment diversification.

Don't put everything into one stock.

Spread risk across different investments.

Retirement planning can apply a similar concept to taxes.

You might have:

Tax-deferred assets — Traditional IRAs, 401(k)s and other qualified accounts.

Taxable assets — Brokerage accounts, bank accounts and other investments.

Potentially tax-free assets — Roth IRAs and other qualifying Roth accounts.

These accounts don't all produce income in the same way.

That matters.

If virtually all of your retirement wealth is sitting inside traditional tax-deferred accounts, you may have accumulated a tremendous amount of wealth—but you've also accumulated a tremendous amount of future taxable income.

That doesn't necessarily make traditional retirement accounts bad.

Quite the opposite.

They are incredibly useful retirement-saving vehicles.

But the tax liability associated with them needs to be considered as part of the overall retirement plan.

The RMD “Tax Time Bomb”

Consider someone who has accumulated $2 million in traditional retirement accounts.

They don't necessarily need to spend the entire account.

They may have Social Security.

They may have a pension.

They may have taxable investments.

They may even have other sources of income.

But the traditional retirement account continues growing.

Eventually, RMDs begin.

Now the retiree may be forced to recognize taxable income from an account they didn't necessarily need to tap for their lifestyle.

That can create an uncomfortable situation:

Your portfolio is growing, but your future tax liability may be growing with it.

That's one reason retirement tax planning should ideally begin before RMDs arrive.

Strategies such as Roth conversions, charitable giving, tax-efficient withdrawals and thoughtful asset location may be worth considering depending on the individual's circumstances.

Income Planning and Tax Planning Are the Same Conversation

You can't really separate retirement income planning from taxes.

Suppose you need $100,000 per year to live comfortably.

The question isn't simply:

“Where do we get $100,000?”

It's:

“Where do we get the $100,000, and what does that withdrawal do to the rest of the financial plan?”

Taking $100,000 from a traditional IRA is very different from taking $100,000 from a Roth IRA.

Taking $50,000 from an IRA and $50,000 from a taxable account produces a different tax outcome again.

And receiving Social Security, pension income and investment income at the same time can further change the equation.

The most tax-efficient withdrawal strategy isn't necessarily the same every year.

Your income changes.

Your tax bracket changes.

Markets change.

Your expenses change.

Your age changes.

Your RMD situation changes.

A retirement income plan should therefore be dynamic, rather than something you create once at age 65 and put in a drawer.age 65 and put in a drawer.