So you really think your tax rate is going to be lower in retirement?

That’s the conventional wisdom the Wall Street Propaganda Machine and the Government sure pumps at us. “It’s a good idea to save for retirement using a 401(k) because once you’re retired your tax rates will be much lower because you won’t be working.”

There are two reasons you ought at least reconsider that conventional wisdom and see if you agree.  One you really have little or no control over.  The other one you may have a great deal of control over depending on your lifestyle.

Statutory Rates

The one you have little to no control over is statutory tax rates.  You see on your pay stub all those withholdings for taxes that your employer makes and probably think you got it pretty bad.  How could things possibly get worse?  The reality is right now we are in a period of historically low tax rates.  The highest marginal (top) rate is near records lows.

Okay so you aren’t in that top tax bracket or think you never will be? You’re “middle class” folks? I got news for you: you are paying historically low rates as well.  Check out this report from The Center on Budget and Policy Priorities

Here’s another graph showing how statutory rates have gone down across income bands

So what’s wrong with this picture? Nothing, if there were corresponding declines in government spending.  Instead we have record levels of government debt.  In fact our government debt now approaches our GDP.

Here’s is a link to one of the scores of sites with data on the scope of the debt.

Politicians, economists and other policy wonks will debate each other about what the “real, true” debt is (most of these numbers don’t include unfunded obligated created by Social Security).  This isn’t meant to be a political discussion, partisan, or in any way assigning blame.  There are plenty of people out there doing that.  Heck, I’m not even going to propose a solution to our debt/spending issue here, I’m just asking for the sake of this blog can you agree with me our current level of money going in vs. money going out (deficit) and the debt it is creating is unsustainable?

In light of that do you think statutory tax rates are likely to go up, down, or stay the same?

Your Own Individual/Household Tax Rate

The other part of this tax rate question has more to do with you and your individual situation.  This one won’t be the same for everyone and you do have more control over it based on your lifestyle.  Conventional wisdom is that “in retirement you only need 80% of your pre-retirement income to maintain the same standard of living” or some such thing.

Here’s what’s missing from that equation: Deductions!

• Mortgage Interest – this is a big one! Even though we’re seeing more & more retirees with mortgages this isn’t part of the plan is it?  Your retirement plan has that bad boy paid off, right?
• Children – a double whammy – they are both an exemption and a credit.  Sure your adult children may move back in and you may support them but as adults they will be too old to qualify as dependents…sorry…
• Retirement Plan Contributions – you know 401(k)s and other “qualified (to pay taxes) plans”??? In retirement those deductions go away…in fact if you are taking distributions that’s where a great deal of your “income” may be from…

Add all those up and any decline in spending is more than offset by bigger declines in income.

The other piece is quality of life/spending.  More available time means more available time to do things and doing things costs money.  Many leisure activities are expensive.  I’m not saying don’t spend.  After all being able to do things (or at least afford to do them) in retirement is aspirational.  Just be realistic about what your retirement will be like.

This is just my observation from working with a number of families and asking them about their tax rates pre and post retirement but not many of them are lower by choice.  If you weren’t frugal before retirement you won’t be happy being frugal in retirement.

So add together the prospect of higher statutory tax rates that aren’t offset by this myth of a lower retirement tax bracket & it begs the question:

Is maxing out your contributions in your qualified (to pay tax later) plan at work really such a bargain?

Concerned about future tax rates? Have you considered a Roth IRA (although there are limits on income, contributions, and early withdrawals) or a properly funded Indexed Universal Life policy?