Have you ever stopped and considered how your marginal tax rate in retirement may be affected by your annuity? The taxes chart that appears below summarizes the basic 2016 federal tax structure. Although every case is different, there is a good chance that you, as a federal employee, will not be in as low a tax bracket as you may think. Many people in the 25 and 28 percent brackets believe they will fall down into the 15 percent bracket—a significant decrease in the marginal tax rate. All too often they find that it doesn’t work out as planned. Thus it is important to consider your taxes in retirement.
Now you may be thinking: But wait! Suze Orman, Clark Howard, Dave Ramsey, and countless other TV and radio personalities have told me again and again that I will drop down to a lower tax bracket upon retirement. This is not always true, especially for federal employees, who receive such robust pensions. The generous benefits that federal employees receive, coupled with the federal tax structure, often keep retirees in the same bracket.
Consider the hypothetical case of two FERS employees, Crystal and Tim, a married couple, who are both sixty years old. Crystal has an annual salary of $133,000, and Tim makes $83,000 per year. They are currently living well within their means. They both plan to retire in two years at age sixty-two. Crystal expects to receive an annuity of $1,710 per month and another $1,582 from Social Security. Tim will receive a pension of $1,756 per month in retirement and a monthly Social Security check for $1,190.
Their salaries put them near the top of the 25 percent marginal income tax bracket while working. They expect to drop into a lower tax bracket when they retire, because celebrity financial gurus have repeated this ad nauseam on TV and in books. Tim and Crystal have been contributing to their individual TSP accounts rather than a Roth account because they expect lower tax rates on their tax-deferred retirement funds.
What Tim and Crystal don’t realize is that their federal pensions will actually keep them in the same marginal tax bracket even after retirement. Marginal tax brackets are generally based upon adjusted gross income (AGI). Their AGI includes 85 percent of their Social Security benefits, since their combined income exceeds specified limits. In order to maintain their standard of living, withdrawals are needed from their traditional TSP which will cause them to remain in the same 25 percent marginal income tax bracket (based on the taxes chart) even after standard deductions and exemptions. We see this almost all the time with “dual-fed” couples, and it is a common occurrence for single federal retirees as well.
Consult the chart below for a breakdown of the 2016 federal income tax brackets, and to observe how Tim and Crystal shift within their marginal income bracket—but not out of it—when they move into retirement.
Keep in mind that tax brackets are subject to change every year. We expect the dollar ranges for each bracket to continue to go up slowly over time due to inflation adjustments, though this is not a given.
Knowing what tax bracket you will be in when you retire is important for retirement planning. Having put their savings in “tax-me-later” traditional TSPs, and not dropping to a lower tax bracket, they missed out on the primary advantage of the traditional TSP. Saving money in a tax-deferred account is often a good idea, but as we can see with Tim and Crystal, changing to Roth savings can provide needed diversification.
Please note: We do not know what changes will occur in the future of the tax system. If taxes increase, Tim and Crystal might save real tax dollars by using Roth accounts; if taxes remain the same, they would maintain the same position by funding tax-deferred accounts. There is no crystal ball though, and the future is uncertain. Thus, we like to follow the advice of the wisest and richest man who ever lived. In Ecclesiastes 11:2 (God’s Word translation), King Solomon says:
Divide what you have into seven parts, or even into eight, because you don’t know what disaster may happen on earth.
The takeaway from this chapter: Everyone’s financial situation is unique, and the tax system is difficult to navigate successfully. You should be working with a tax professional and financial professional who are knowledgeable about federal benefits in order to minimize the bite that taxes will take out of your retirement savings, both now and later. While it is never too late, planning for the future early will help you optimize your tax efficiency.
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The information contained in this article should not be used in any actual transaction without the advice and guidance of a tax or financial professional who is familiar with all the relevant facts. The information contained here is general in nature and is not intended as legal, tax or investment advice. Furthermore, the information contained herein may not be applicable to or suitable for the individuals’ specific circumstances or needs and may require consideration of other matters. RBI is not a broker-dealer, investment advisory firm, insurance company, or agency and does not provide investment or insurance-related advice or recommendations. Brandon Christy, President of RBI, is a registered representative of Christy Capital Management, Inc. (CCM), a registered investment advisor.