Retirement Income Is More Variable
What sets out retirement income the most from the earned income that we get in our careers is that we choose our retirement income levels as well as the amount of tax we pay much more in retirement.
While there are certain things that we can do when working to reduce our tax burden, including setting more of our income aside for retirement, when we retire, in many cases, we’re going to decide how much of our savings we will be declaring as income and spending each year.
If we have not saved up anything and are just getting by on our pensions, then this of course won’t apply, but assuming we do have some savings that tax has been deferred on, we will indeed choose how much of that to take out each year.
Having at least a good idea of how much of this we will need is therefore going to impact our decisions, not only after retirement but even well before it, as we decide what our marginal tax rates may be in retirement, which will be dependent in part on our spending needs then.
The investment industry does try to help us with this, but their estimates tend to be too much on the optimistic side versus what really happens. The accepted standard is 70% of our working income, which might be fine for some people, but whenever you use a generalization like this, you risk this missing the mark in some situations.
The problem is that achieving 70% here is enough of a challenge for a lot of people, especially those who aren’t starting out saving enough for this early in their careers, which is a lot of people.
The correct number for a given retire will depend a lot on one’s tax rates, and what dropping down to 70% or some other number will have on their net income, if we are using gross income.
It is improper to ever use gross income in these projections actually, as net income is the only income that really matters, how much we have now and how much we will need in retirement.
It turns out that often times we will find that our net income dropping by 30% will be too much, but this all depends a lot on a number of other factors, and especially how well off we were on the net income we earned while working.
Some people live pretty close to the edge financially with what they make while working, and with those people, which include a lot of people actually, there will be less tolerance to drop down than with those who may have been living more abundantly and could drop down without much hardship.
Even so, tax rates do matter here, and especially matter when it comes to managing our tax rates in retirement. Looking at net income will provide us with a better idea about what our needs will be in retirement, but when in retirement, the tax man will still have his hand out and we still need to be aware of not handing over too much.
Changing Tax Rates
Paying less in tax starts with spending less, which is why looking at spending needs to be the starting point in these calculations. While dropping to a lower tax bracket may seem appealing, if we cannot reduce our spending to the point where we can do this, thinking about this or assuming it isn’t going to be of any value because it won’t come to pass.
It is not enough to look at what percentage of our overall income goes to income tax, even though this matters as well. What we need to do though is to break down our income or projected needs according to the tax brackets in place where we live or plan on living.
Moving to a different locale where tax rates are lower is certainly something worth considering if one is open to the idea, but in any case, there will generally be brackets where income becomes taxed at different rates, and we need to be aware of this.
The first bracket is generally not taxed, where one can use personal deductions to reduce the amount of income tax they owe to zero. Many retirees actually have their entire income in this bracket and do not pay income tax, but these are the people whose income is low and just barely get by.
From there, we move up to higher brackets with a progressively higher rate of income tax. The reason it pays to be aware of where these brackets reside is that this may affect our decisions to declare more or less income in a given year.
When we’re employed, we really don’t have that many options here, as our income is determined by how much we make. In retirement, we’re not employed, and if we’re tapping into our savings, there will be a certain amount that we have to take out, but beyond this, there may be some flexibility.
It may even end up being the case that we may want to take out more than we need and declare this as income, for instance up to the upper limit of the tax bracket we’re in. In some cases, such as if we are in the lowest tax bracket, we may even be declaring extra income without paying any tax at all on it, by looking to maximize the amount of income we may declare without paying tax.
In higher tax brackets, if we know that we will pay a certain rate of tax on amounts beyond our needs, it can also make sense to declare it as income in certain situations. At a minimum though, we need to be aware of where we are at in reference to the tax bracket that we are in, and how much more we can take out and remain in the same bracket should we choose to.
There will be a certain amount that we will need though, but for a lot of people, there may be a certain amount of flexibility here, for instance with their ability to cut down on spending somewhat if it benefits them. There also may be some larger purchases that they may be able to defer that may provide them with tax benefits in doing so depending on the tax rates in play.
This is one of the reasons why we should generally look to take out money from our savings and declare it as income if we can do so and remain in the same tax bracket, to be able to build up a nest egg of already declared income in our savings, which may be used for larger purchases without running the risk of raising our tax bracket and paying a higher tax rate on this extra money.
Managing our taxation rates may be seen as a fairly minor issue by a lot of retirees and those planning for it, and while it is true that spending levels tend to be a bigger deal, managing your taxes does allow for the ability to spend more over time and also be better situated in retirement.
It therefore pays to at least be aware of the tax implications of your spending and needs in retirement so that we will be prepared to make changes to our benefit when warranted and needed.