Myth – Your taxes will go down in retirement

interest rateThis thought is so wide spread it is commonly accepted as truth. In fact, this seems to be so ingrained it is almost an excuse not to have to save that much for retirement  … “Why save so much when taxes will be less?” So why do I say this idea is a myth?

Let’s walk through this by starting with your tax return. This will be a broad and basic discussion to keep it simple so the concepts stand out easier.

First, the top total earnings line does NOT include what you have contributed to your 401k, 403b, 457, etc. plans (any IRA contributions may also be deducted if you meet those rules). I bring this up because people think that because they are contributing toward retirement, say for example 15% (or whatever % you’re deducting), that their taxes, or taxable income will go down by 15% when they retire. That money you contributed was not taxed before, and you didn’t spend it either (you saved it), so it doesn’t change your taxable income,* and your spending won’t go down by that much because it already has, through the very act of saving.

Maybe it would be easier to mentally visualize this if you thought of the big picture in terms of your Standard of Individual Living (SOIL). You are being taxed on your level of SOIL … the money that you spend in life.

Looking at the income tax rates** you can see how much you would need to reduce your spending to get into a lower tax rate. And here’s the trick on that. Even in the higher tax rate, all the money up to that lower point was taxed at the lower tax rate. So, it is only the money OVER that dollar amount that has the higher tax rate applied. For example, let’s say you are single and your taxable income is $90,000. Then, your tax is $18,193.75 PLUS 28% times $90,000 minus $89,350 ($650), or only $182 extra tax. You would need to reduce your taxable income (Standard of Living) all the way to UNDER $36,900 to reduce your tax rate from 25% to 15%.

2014 tax rates

Only if you are on the cusp with your taxable income will you change your tax rate by spending less (spending in retirement is what triggers taxes from 401k, 403b, 457, IRA). My experience tells me that most people are well within their bracket or close to the top of it. You can look at how close, or far, you are to the top, or bottom, of your bracket in the table above. People in the upper part of their tax bracket would need to cut their spending (also called reduce their standard of living) by quite a bit to lower their taxes. Cutting spending at retirement may be required because one has not saved enough.

There’s a better way. Save more now towards what you need to sustain your present SOIL. Behaviorally, saving more means spending less – however, saving more feels better than cutting spending – even though the effect is the same – because saving more feels like you are accomplishing something. There is actually a benefit to saving more too … it makes it easier to reach your goal. See the Dynamic Effect of Saving More.


Result: if you keep your present standard of living in retirement, your taxes will be the same too. Although it is called an income tax, you could essentially say it is a Standard of Living tax (or, since you spend all you don’t save – it may be called a form of consumption tax too).

Moral of the story: Calculate your Standard of Individual Living (SOIL) today. Reduce it by what you are paying into Social Security to get an idea of what Retirement SOIL you are trying to save for. Plan on paying taxes then as you are today. Tax rates could go up, or they could go down. But, you can’t plan on “could.” Make adjustments along the way. Isn’t this how life is lived, and has been lived?

Here is a blog post that describes what most people think about when it comes to cutting taxes.

*You do get a break from not having to pay into Social Security and Medicare (FICA = 12.4% + 2.9%; excludes the Affordable Care Act here). And, eventually Social Security will eventually begin to add to supporting your SOIL. Your “retirement” SOIL may be calculated to be 12.4% less than your “working” SOIL. I suggest you don’t reduce the SOIL for Medicare because you will need funds to continue to pay for health care once retired.

** … enter “Form 1040-ES” in the search box. Tax rates for other filing status’ may be found within the form.

PS. Think Roths solve all this? Think again – Affordable Care Act surtax may take a bite out of your Roths too.

About Larry Frank, Sr.

Larry R Frank Sr., MBA, CFP®, is an experienced financial advisor and a published author on Retirement Planning Research. Have a financial question? Click Here to Ask Larry

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