Why Your Taxes Could Increase In Retirement - And What You Can Do About It Now
In this report, you will learn:
- Why you may not want to defer taxes until retirement
- Which social and economic factors may contribute to a tax hike in the future
- Tax planning ideas you can use today to take advantage of low rates
- The importance of establishing after-tax savings for your future retirement
Based on our experience, many people in the university community who are nearing retirement assume their tax liability will decrease in retirement. This belief is mirrored by the fact most university retirement plans are automatically set up to defer all taxes until a distribution is made to the retiree – presumably at a lower income tax rate than when they were working.
However, what if we are already in the lowest income tax rate environment we will see for the rest of our lives? Based on many social and economic factors, we may have the perfect recipe for significantly higher tax rates in the future. The tax environment we’re currently in calls into question the old strategy of “defer, defer, defer,” in favor of establishing after-tax retirement savings.
This report will explain why taxes may be on the rise in the future and provide you with valuable tax-planning strategies you can use today to take advantage of historically low rates, keeping you in control of your tax liability in retirement.
Understanding the Landscape
For many years the rationale on retirement tax planning was simple; defer as much of your current income as possible in pre-tax retirement accounts and pay taxes down the road in retirement when your income will be less. Professors seem to have followed that rule “to a T.” In our experience, most university professionals typically have 90% or more of all retirement savings in pre-tax accounts.
However, this rule is predicated on the assumption that an individual’s tax rate will be lower during their retirement years. From what we see in the current tax landscape, it’s actually more likely that rates will increase in the years to come. A professor could be deferring taxes now, only to pay a substantially higher tax rate on their retirement income in the future.
Today, income taxes are at historically low rates. In 2017, the Tax Cuts and Jobs Act (TCJA) was passed. Among other changes, this act lowered the effective tax rates for individuals and dramatically widened the income range for some of the middle tax brackets, especially for married couples. Lower tax rates lead to substantially lower revenue and rapidly increasing debt for the government, which is a key indicator that tax rates may increase in the years to come.
These lower rates are set to revert back to what they were prior to TCJA in the year 2026. However, depending on the results of the 2020 election, changes could be made sooner than that. With our nation’s budget deficit projected top $1 trillion in 2020, and the social programs being discussed on the campaign trail, all signs point to higher taxes ahead.
While no one has a crystal ball, the most proactive solution is to pay some taxes today at what are likely to be the lowest rates we will see. In a tax environment like this, deferring income taxes for retirement may not be the best strategy. The more after-tax savings you can establish today, the more flexibility you will have over your tax liability as you generate retirement income in the future. If your tax rates do increase, you will have savings you can draw from that will not be subject to income taxes.
How to Establish After-Tax Savings
There are several options for a university professional to continue saving for retirement while maximizing the current, low income tax rates. Below are a few options to explore.
Roth IRAs are an attractive way to save after-tax money for retirement. Instead of deferring income taxes until a withdrawal is made, an individual makes their contributions with after-tax dollars. If a few criteria are met, (the individual reaches age 59.5 and waits at least 5 years from the time of the first contribution) this money will never be taxed again—even the growth. If an individual falls within the IRS income limitations, both spouses can each contribute up to $7,000 to a Roth IRA account annually (if age 50 or older).
If an individual is over the income limitations for a Roth IRA contribution, there are few other options to consider. Many university retirement plans have introduced the option to make Roth contributions to voluntary retirement plans over the past several years. This option is particularly attractive because there is no income limitation on Roth contributions for employer-sponsored plans, so every faculty member is eligible. Also, the amount you can contribute to a Roth 403(b) is substantially higher—$26,000 annually if you are age 50 or older, per the 2020 IRS limits. Some universities even have an additional Roth 457(b) plan that would allow you to contribute as much as an additional $26,000, for a grand total of $52,000 in potential annual Roth contributions in the university retirement plans.
There is one idiosyncrasy to be aware of with Roth 403(b) and 457(b) accounts available through the university. Unlike a Roth IRA, the IRS rules require university Roth plan participants to adhere to the same Required Minimum Distributions (RMD) rules as pre-tax retirement plans. (There is a fairly simple workaround to this rule by rolling these funds out to a Roth IRA prior to RMD age.)
If you are over the IRS-dictated income limitations for Roth IRA contributions and your university does not offer a Roth 403(b) or 457(b), there are still some additional ways you can establish Roth savings. Backdoor Roth and Roth conversions are fairly complex planning concepts and will likely require professional assistance to navigate the tax laws, but it is possible to establish Roth savings for nearly anyone earning an income.
Another option is to invest after-tax money in an investment brokerage account. Money invested in a brokerage account doesn’t qualify for quite the same favorable tax treatment Roth accounts receive, but it is still a good option. If you buy a stock, bond or shares of a mutual fund or Exchange Traded Fund (ETF) in this type of account, you will only have to pay taxes on the growth you receive, and only after the investment is sold. Additionally, this growth is taxed at capital gains rates, which are typically less than income tax rates.
Investors should be aware, however, of the annual taxes that can impact a brokerage account. Income earned from interest-bearing investments, like bonds, is taxed at ordinary income tax rates. Mutual funds pass dividend and capital gains income through to the investor, and are typically taxed at capital gains tax rates. This type of passive investment income can be avoided by utilizing exchange traded funds (ETFs).
As you can see, there are several different options you can use to establish after-tax savings, and each has its own set of pros, cons, and rules regarding tax treatment. By working with a qualified professional with expertise in both tax and retirement planning, you can identify which after-tax retirement savings opportunities are right for you.
Don’t Wait to Take Action
Spending some time on proactive tax planning today can make a tremendous impact on your future retirement. With an uncertain tax environment looming in the future, university professionals should do all they can now to retain control of their future retirement savings. While most professors do not object to paying taxes, no one wants to deplete their retirement savings any faster than is necessary. Income taxes in retirement can already be a more costly expense than many anticipate, and economic factors indicate that it may only get worse in the future.
It is very important that you work with a qualified financial adviser and consult a CPA when necessary to do effective tax planning and make sure you don’t run afoul of any tax laws. With some effective planning today, you can take advantage of historically low tax rates, and give yourself much more control of your tax rates later in retirement. To speak with an expert on our team about proactive tax planning, call 844-948-0894.
The information provided is not, nor is it intended to be, legal advice. You should consult your attorney for advice regarding your individual circumstances.
Circular 230 Disclosure
We are required by Treasury Regulations (Circular 230) to inform the readers of this material that, to the extent that the information contained herein concerns federal or state tax issues, such information was not written or intended to be used, an cannot be used, for (1) avoiding federal or state tax penalties or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein.
- To learn more about tax planning in the investment process, read this report: Don't "Beat the Market," Maximize Your Bottom Line
- To learn about the importance of seeking guidance from an independent fiduciary, read this report: Who Can You Really Trust With Your Financial Future?
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