Tax rate risk is an often-overlooked risk that can have a significant impact on retirement savings. Let’s discuss what tax rate risk is, how it can impact your retirement, and some strategies you can use to mitigate this risk.
What is Tax Rate Risk?
Tax rate risk is the risk that tax rates will increase in the future, which can impact the value of retirement savings. Tax rates can impact retirement savings in several ways, including how much tax you pay on distributions from retirement accounts and the value of tax deductions.
No one can predict the future of tax rates. However, two forces working together would argue that tax rates will almost certainly be higher in the future. First, the US is saddled with crushing debt that only grows year after year. Second, tax rates are historically low. The US will never pay its debt at current tax rates. It’s simply mathematically impossible. At some point, tax rates will need to rise.
Tax Rate Impact Retirement
Tax rate can impact retirement savings in several ways. One way is through distributions from retirement accounts. Withdrawals from tax-deferred retirement accounts, such as 401(k)s and traditional IRAs, are taxed as ordinary income. If tax rates increase, the amount of taxes paid on distributions from retirement accounts will also increase, reducing the amount of retirement savings available for living expenses.
Many investors are unaware that withdrawals are taxed at the tax rate at the time of withdrawal, not tax rate at which the money was deferred. You could save at a low tax rate, only to have the money withdrawn at a much higher tax rate.
Mitigate Tax Rate Risk in Retirement
One strategy to mitigate tax rate risk is to diversify retirement savings wisely across different types of accounts based upon the intended use of the money. For example, keep a minimum of money, short-term and emergency savings only, in a taxable account.
The vast majority of savings intended for use as retirement income should be kept in accounts completely unaffected by tax rates. These include Roth IRA and Roth 401(k) accounts, and cash value life insurance. The money held in these two types of accounts is not subject to capital gains taxes or income taxes. Plus, distributions have no impact on your AGI, which means your social security remains tax-free.
Another strategy is to use tax-efficient withdrawal strategies. For example, retirees may want to withdraw funds from taxable accounts in years with lower tax rates or early in retirement. Withdraw from Roth accounts and cash value life insurance in later years to give that money more time to grow or when taxable income is higher.
Retirees can also consider deferring Social Security benefits. Social Security benefits are taxed based on the retiree's income. By deferring Social Security benefits, retirees can reduce their taxable income and potentially reduce the amount of taxes paid on Social Security benefits.
Tax rate risk is an important consideration for anyone planning to retire. Understanding this risk and implementing strategies to mitigate it helps ensure that retirement savings last as long as necessary to maintain a reasonable standard of living in retirement.
Finally, retirees may want to consult with a financial advisor or tax professional to develop a tax-efficient retirement plan. A financial advisor can help retirees understand the tax implications of different investment and withdrawal strategies and develop a plan that meets their unique needs and goals.