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.