Why you may not have as much saved for retirement as you think
Broadly speaking, the retirement-savings situation among today's workers is bleak, even among those who are nearing retirement age. In fact, close to half of baby boomers have no savings at all, according to a report from the Insured Retirement Institute. Furthermore, among those boomers who do have savings, more than a quarter have less than $100,000 set aside.
If you're light on assets, you'll need to find ways to stretch every dollar in retirement. Unfortunately, there's one financial factor you may not be accounting for, and it will take a bite out of whatever nest egg you have.
The hidden risk you could be overlooking
As you're planning and investing for the future, it's easy to look at the sum of your retirement account balances and assume that the number you see is the amount you'll be able to spend. If you do, you're forgetting one expense that is sure to alter the math: taxes.
If you're investing through a 401(k) or traditional IRA, you get tax breaks when you contribute, but you will owe income taxes on your withdrawals in retirement. And if you're not budgeting for that, it could throw off your entire retirement plan.
Exactly how much you'll owe in income taxes will depend on how much you withdraw from your retirement accounts. If your spending levels in retirement are similar to what you spent in the years prior, you may stay in the same tax bracket. But if you plan to spend significantly more in retirement, your withdrawals from those retirement accounts could push you into a higher one.
As of 2020, here's what the various tax brackets look like depending on your taxable income:
| Tax Rate | Taxable Income for Individuals | Taxable Income for Married Couples Filing Jointly | Taxable Income for Heads of Households |
|---|---|---|---|
| 10% | $0 to $9,875 | $0 to $19,750 | $0 to $14,100 |
| 12% | $9,876 to $40,125 | $19,751 to $80,250 | $14,101 to $53,700 |
| 22% | $40,126 to $85,525 | $80,251 to $171,050 | $53.701 to $85,500 |
| 24% | $85,526 to $163,300 | $171,051 to $326,600 | $85,501 to $163,300 |
| 32% | $163,301 to $207,350 | $326,601 to $414,700 | $163,301 to $207,350 |
| 35% | $207,351 to $518,400 | $414,701 $622,050 | $207,351 to $518,400 |
| 37% | $518,401 or more | $622,051 or more | $518,401 or more |
Source: Internal Revenue Service
Remember, income tax is progressive -- you won't pay a single tax rate on your entire income. So, for example, if you and your spouse withdraw $60,000 per year from your 401(k), that puts you in the 12% tax bracket. However, you won't pay 12% on the full $60,000. Rather, you'll pay 10% on the first $19,750, then 12% on the remaining $40,250.
How to save money on taxes in retirement
As you head into your senior years, it's important to have a tax strategy in mind, and investing in a Roth IRA is a smart way to reduce your tax burden in retirement. You'll have to pay taxes on the money you contribute to a Roth upfront in the year you invest it, but your withdrawals -- including the account's gains -- will be tax-free. This can make your withdrawal plan more straightforward, because the amount you take out will be exactly as much you'll have available to spend.
If you have some savings in a 401(k) or traditional IRA and some in a Roth IRA, you can minimize your tax bills by being strategic about which account you tap. For example, during the years of your retirement when your expenses are higher -- like when you're traveling extensively or paying for expensive home renovations -- you can primarily withdraw funds from your Roth IRA since that money is tax-free. Then during years when you need less, you can withdraw primarily from your 401(k) or traditional IRA.
Keep in mind, however, that once you reach age 72, you'll need to start taking required minimum distributions (RMDs) from your 401(k) or traditional IRA. That means you'll need to balance your RMDs with the amount you choose to withdraw from your Roth IRA. And because Roth IRAs are not subject to RMDs the same way 401(k)s and traditional IRAs are, that's another incentive to start investing in that type of account now so the majority of your retirement income will be tax-free.
You may also choose to convert a portion of your traditional IRA to a Roth IRA. Just make sure to do this during a year when you're not withdrawing as much from your retirement fund, since you'll have to pay income taxes on the amount you convert when you do it. But this strategy can ultimately save you a lot of money if you experience several high-spending years down the road.
You won't be able to avoid taxes entirely in retirement, so being aware of how they'll impact your income is crucial. By crafting a tax strategy before you retire, you can potentially save thousands of dollars and help your nest egg go further.
This article was written by Katie Brockman from The Motley Fool and was legally licensed through the NewsCred publisher network. Please direct all licensing questions to legal@newscred.com.
