I think most people would agree that if they could retire on an income of $100,000 per year, they would be pretty happy in retirement.
In fact, I would suggest that many would jump at the chance of retirement if they knew they could spend $100,000 per year.
If this simplified assumption is true, it begs the question, what does it take to get there? How can a person save enough to create an income of $100,000 per year in retirement?
Depending on your stage of life, you may be asking some key questions:
How much do I need to have saved before I can retire?
The answers to these questions are only part of the answer. There are additional questions that need to be asked as well, and these pertain to other income sources and other retirement tax projections.
When we ask all of the relevant questions, this more accurately represents the real questions most retirees want answered.
How Income Taxes Impact Retirement
If you need $100,000 per year in retirement, you most likely will need to have a total income that is significantly higher than $100,000. Why, you ask? You need to account for income taxes of course.
In fact, the pre-tax amount you need may be wildly different from the after-tax amount that you are counting on. These numbers are subject to income taxes, and how much tax you actually pay will be dependent upon where your income is from and how your distributions are sourced.
For example, pension income has different income tax rules than does Social Security income. One is fully taxed at ordinary income rates, and the other is only partially taxed (or not taxed at all).
Additionally, Roth IRA distributions are taxed differently than traditional IRA distributions. In fact, they are taxed so differently that (with a few exceptions) Roth IRA distributions aren’t taxed at all!
So one could argue that taxes are a huge part of any retirement plan.
In fact, by understanding income taxes and how your different accounts are affected by them, you can begin to make decisions regarding the best place to take distributions.
A hypothetical illustration, using 2018 tax code (and actual Lacerte tax software), of a $100,000 income should help further explore the differences.
In this example, we make the following assumptions for each scenario:
- A married couple, both 62 years of age
- Both collecting Social Security at $20,000 each, for a total of $40,000
In an effort to test the impact of taxes, we have assumed the following four examples:
- The couple takes a withdrawal of $60,000 from a Roth IRA.
- The couple takes a withdrawal of $70,000 from a traditional IRA.
- The couple takes a withdrawal of $60,000 from a non-IRA investment account.
- The couple takes a withdrawal of $61,000 from a non-IRA investment account.
In each of these four scenarios, the after-tax retirement income received by the retirees is nearly identical at $100,000. As illustrated below:
|Case 1||Case 2||Case 3||Case 4|
|Total Income and distributions received by retiree||$100,000||$110,000||$100,000||$101,000|
|Less income tax||$0||$9,485||$0||$1,003|
In each of these examples, the retired couple fundamentally received the same amount in the end. However, the amount of distributions required to create that same after-tax income are different. In the most extreme case, there is a difference of over 20% (when comparing Roth IRA distributions to traditional IRA distributions).
These differences are due to the taxes incurred by the income and distributions. To get an even better understanding, let’s explore how different distributions are taxed.
- Roth IRA distributions – Roth IRA distributions (if qualified) are nontaxable. They also do not increase adjusted gross income (AGI). Because the AGI is below the limits set by the IRS, none of this retiree’s Social Security is taxable.
- IRA distributions – IRA distributions are taxable as ordinary income and do increase AGI. ). A higher AGI may mean a higher percentage of Social Security is taxable.
- Non-IRA investment distributions – Non-IRA distributions are taxed at capital gains rates. Long-term capital gains may be taxed at preferential long-term capital gains rates. For our example, we have assumed the basis of the $60,000 distribution was $60,000. The tax impact of this is zero. This means there is no tax due and no adjustment to AGI.
- Non-IRA investment distributions – In this scenario, we have assumed a $62,000 distribution with a basis of zero. For tax purposes, this is a long-term capital asset that is taxed at favorable rates. It does, however, increase AGI, making 85% of Social Security taxable.
By charting these words from above, we can illustrate the tax impact (and opportunity) more clearly.
|Case 1||Case 2||Case 3||Case 4|
|Total Taxable Income||0||$80,000||0||$71,000|
|Total Tax Due||$0||$9,485||$0||$1,003|
You’ll notice that in scenario 1 and scenario 3, the total taxable income is zero. This means that the retiree was able to receive $100,000 of income and distributions without paying a penny in taxes!
In scenarios 2 and 4, the total taxable incomes are $80,000 and $71,000 respectively. This is a combination of IRA distributions and capital gains being taxed as well as part of the Social Security income.
How Can I Plan?
One simple answer to this question may be to diversify.
We often hear the term diversify as it relates to investments. In short, this just means that you shouldn’t put all your eggs in one basket.
This same line of thinking can be used for account registration. It may not make sense to invest all your savings into a pre-tax IRA and/or 401(k). If you are willing and able to forego a tax deduction now, it may make for less tax liability in the future.
You can also plan more specifically by using the distributions above to calculate how much you may need to retire comfortably.
For example, if we use a 4% withdrawal rate as rule of thumb and assume only Roth IRA savings and a $60,000 need, as illustrated above, we can suggest a savings target of $1,500,000.
Assuming 4% and traditional IRA money (therefore a $73,000 distribution), the total amount of money needed to retire is $1,825,000.
What Have We Learned?
In short, if you want to live off of $100,000 in retirement, you should pay particular attention to not only how much money you are saving now but also where you are saving it.
Does it make sense to only have money invested in a traditional IRA, or does it make more sense to have Roth IRA or non-IRA investments?
The answer to the question of “Where am I saving?” is just as important as the answer to the question of “How much am I saving?”
Contributions to a Roth IRA are not tax deductible and there is no mandatory distribution age. All earnings and principal are tax free if rules and regulations are followed. Principal contributions can be withdrawn any time without penalty (subject to some minimal conditions).
Contributions to the Traditional IRA may be tax-deductible depending on the taxpayer’s income, tax-filing status and other factors. Taxes must be paid upon withdrawal of any deducted contributions plus earnings and on the earnings from your non-deducted contributions.
None of the information in this document should be considered tax advice. Please consult with your tax advisor for more information concerning your individual situation. Tax services are not offered through, or supervised by, Capital Analysts or Lincoln Investment.