May 29, 2012

Taxes in Retirement

One major aspect of retirement planning is the tax bill you'll face in retirement.   Figuring your future tax bill has a couple major implications.  First the tax expense itself is a major line item in your budget and you should plan appropriately.   You don't want to figure out a post-retirement budget and totally neglect or severely misjudge your tax obligations.   Also the taxes you pay in retirement will help determine if a pre-tax retirement fund or post-tax retirement fund is appropriate. 

Most people face lower tax bills in retirement.    Income is lower and senior citizens get some special tax breaks.   There is a common fear today that taxes will inevitably go up in the future.  This may be true to some extent but taxes are quite variable based on income level and its unlikely taxes will go significantly for low/middle income earners.  Overall though the tax breaks and lower income of retirees should generally outweigh future tax hikes. 

There is a general exception to this.  If you are in the top tax bracket during your earning years and you also expect to be in the top tax bracket in retirement then you may see higher tax rates post-retirement.  But that situation likely only applies to the top 1% of income earners in the population and for the other 99% of us we're much more likely to see lower tax rates post retirement.

Taxes post-retirement come in several forms.   WE pay taxes to the federal government, usually states have income taxes and property owners have property tax bills.  Lets look at each of these and discuss how your tax rates could change after retirement.

Federal Taxes

For example sake lets say you currently make $100k in wage income today.   You are in the middle of the 25% tax bracket.  You also normally pay 7.65% into social security and medicare.   Thats a combined marginal tax rate of almost 33% and an effective tax bill of approximately 20% or $20k.  When you retire you stop paying SS/med so thats a 7.65% tax cut effectively.  But of course you don't still have that $100k income and you probably have more like $80k right?   Since you were making $100k you have a good SS benefit and $25k of your income is SS.  Only 85% of your SS is taxable so thats more like $76k taxable income.   That $76k taxable income would put you in the 15% margin bracket in todays rates and give you about 10% effective tax rate or $7600.

So if nothing changes in the tax laws and your income pre-retirement is $100k and $80k post retirement your tax bill will drop by approximately $12,400.   The effective tax rate will go from 20% to 10% and your total marginal bracket including FICA will drop from 33% to 15%.

Do you think that marginal taxes rates are going to go from 15% to 33% for retired people making $80k??   Do you think politicians are going to double the effective tax rates for a married retired couple from 10% to 20%? 

I sure don't.  That's kinda silly.  For anyone who thinks this is feasible or likely within the next decade or two then I'd challenge anyone to find two politicians in our federal government who want to raise taxes on ANYONE by 18% marginal.

You may have notice I put a qualifier of 'within the next decade or two' in that last sentence.   I would admit that 40 or 60 years from now things could radically change in our government.   It was only 50 years ago in the 1970's when top marginal tax rates were 70% and now the top rate is currently half that at 35%.    You really can't plan for 50 year time periods.   50 years from now the  Martians may have taken over after we blow ourselves up with a nuclear war with India after the solar flares knock out all the electric grids and the zombie apocalypse... oh.. sorry.. what were we talking about?  Oh Yes, taxes in the distant future are anyones guess and not something you can predict nor plan for.   If you'd have told your grandparents 50 years ago that taxes would be cut in half by now they'd have probably scoffed at the idea, yet it happened.    Nobody can predict government policy 50 years into the future and anyone trying to do so is just taking blind stabs in the dark.

State Income Taxes

The majority of states do not tax social security.   That is probably the biggest reduction in  state taxes for retirees.   States also usually have some sort of income tax cut for senior citizens.   Usually there is a larger exemption of some sort.  So often your tax bill is a little lower simply due to the age based benefit.   Many states do not tax pensions in general  : Alabama, Hawaii, Illinois, Kansas, Louisiana, Massachusetts, Michigan, Mississippi, New York, and Pennsylvania.   Few people have pensions nowadays but for those who do this can be a considerable benefit in some states.

Between the various tax benefits for senior citizens in the various state income tax systems, most retirees will see sizable drops in their state income tax bills post retirement.  But this is quite dependent on the state and your financial specifics.   I won't make any broad generalizations about the future of state taxes since we've got 50 different states with varied fiances and political climates.

Lets look at an example.   Say you live in California with its relatively high state taxes.   Pre retirement you have an income of $100,000 and your CA tax bill is around $3700.    Post retirement your income is down to $80,000 total but they don't tax the $25,000 from social security so your taxable income is just $55,000.  Also CA has an extra tax credit for senior citizens.   As a retired couple with $80,000 income your CA state income tax is down to just $652.    Thats about a $3000 tax cut in your state taxes after retirement.  

Of course every state is different and state income taxes treat retirees differently.  In some states you may not see a significant change in your state tax bill and in other states your taxes may be dropped to zero.  The future could hold anything here as well.

Property Taxes

This one varies from state to state generally and may also vary between cities or counties within each state.   So there are likely 1000's of different systems for property taxes across the nation.   However many states and local governments offer deferrals, discounts or exemptions on property taxes for senior citizens.   Usually such programs have an income limit but many seniors can qualify.  

Going back to the California example.  Say you live in San Mateo county.    There is a program in CA which gives property tax assistance for seniors and disabled individuals but they limit it to people with incomes under $40,000.    In our example the post retirement income is $80,000 total so that would be too high to qualify for the property tax assistance.

Other taxes

Most of the other taxes we pay are consumption taxes based on a % of purchases.   General sales and excise taxes fall into this category.   I don't know of any special sales tax rates for retirees so I don't expect thats common at all but feasibly I guess it could exist somewhere.   For the most part though I think sales or excise taxes are pretty predictable as a % of your spending and likely won't vary post -retirement other than any changes in spending amounts.   

Estate taxes are another major category of taxation that some retirees do need to be aware of.   Estate taxes however only come into play if you're a millionaire.  If you are a millionaire and likely subject to estate tax then I'd recommend working with an estate planner.


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