I want to share some insight with you from another advisor. Why? Because this article by Steven Jarvis, CPA is a SmartAsset financial planning columnist. This article backs up what I share with my clients and teach at seminars.
I recently attended a retirement seminar at a local community college where the instructor talked about potentially higher tax rates in retirement due to the new RMD age. I have been under the impression throughout my saving career that tax rates in retirement are supposed to drop, especially if you pace your withdrawals. How can tax rates in retirement be higher than your earning years?
Let’s start with the simplest answer and then build from there. Required minimum distributions (RMDs) are certainly a reason that a person’s tax rate might go up in retirement, but they’re not the only reason. There are a number of possible scenarios in which a person faces higher taxes in retirement when compared to their earning years. (And if you need help with planning for taxes in retirement, consider matching with a financial advisor.)
New RMD Rules Could Lead to Higher Taxes
Under the SECURE 2.0 Act, the age at which required minimum distributions (RMDs) start rose from 72 to 73 in 2023. With that change, any money invested on a pre-tax basis in a 401(k) will have an extra year to grow before you have to start withdrawing the money. This means you could have a larger balance that has to be distributed each year once RMDs kick in, and with it, a larger tax bill.
Keep in mind that the RMD age is set to increase to 75 in 2033. As a result, anyone who turns 75 that year or later can leave their savings invested for an extra three years when compared to the previous rules. More time in the market could mean even a larger balance that has to be distributed each year. These larger distributions could potentially push you into a higher tax bracket. (And if you need help planning for RMDs, consider talking with a financial advisor.)
Larger distributions can also trigger Medicare’s income-related monthly adjustment amount (IRMAA), leading to higher monthly premiums for Medicare Parts B and D.
Having More Income
Many retirees who earned a healthy salary and did a great job saving are surprised to find that their income may actually increase in retirement. While up to 85% of Social Security benefits are taxable, the combination of those payments and retirement account withdrawals can add up to a significant income. Add in pension income, taxable investments, rental income and part-time work, and a retiree may find themself in a higher tax bracket than during their primary earning years.
Inheriting pre-tax money can also drive up income in retirement since inherited IRAs have a 10-year window to be fully distributed. In other words, the full amount of the inherited IRA will be added to the beneficiary’s income within 10 years. (And, if you need help managing your income streams in retirement, this tool can help you match with a financial advisor.)
The ‘Widow(er)’ Tax
The widow(er) tax is an oft-overlooked tax rate increase that affects married couples when the first spouse dies. In retirement, the death of a spouse often doesn’t result in a significant reduction in income. But the surviving spouse’s retirement income is now subject to the “single” tax bracket, instead of the much preferred “married filing jointly” bracket.
For a couple with $50,000 in taxable income in retirement, this could increase taxes each year by close to $1,000. For a couple with $100,000 in income, the tax increase would be closer to $5,000. (A financial advisor can help you navigate financial changes that may affect your tax situation.)
Large One-Time Expenses
A retiree may plan to take their pre-tax distributions evenly over time, but life rarely goes exactly as planned. People might pay higher taxes in retirement during years when large distributions have to be taken from a pre-tax account to cover one-time expenses. Hopefully, that distribution is for something fun like an RV or a trip with grandkids, but it might be needed to pay for a new roof or long-term care. In either case, taking a lump sum distribution will drive up your income tax bill and IRMAA for that year.
Tax Code Changes
The tax code is written in pencil. While some provisions of the tax code seem less popular to adjust, none of it is set in stone. We already know that tax rates are scheduled to go up in 2026 after the expiration of the Tax Cuts and Jobs Act (TCJA) so it’s a matter of “when” and not “if.” Historically speaking, tax rates are at all-time lows so it’s also understandable that taxpayers expect further changes to be made to the tax brackets in the coming years.
Some will downplay the impact of the TCJA rate expiration because the changes are only three to four percentage points. But for some brackets that translates to a 25% increase in the taxes you pay. For example, the 12% tax bracket will move to 15% (for married couples filing jointly, this applies to income up to $89,450). That means that your taxes overnight would increase by over $2,000 from that one bracket alone. (And, if you need more help planning for potential tax rate increases, consider speaking with a financial advisor.)
When it comes to tax planning we have to consider more than just the lifetime of the taxpayer. Pre-tax money that is passed on to heirs will still be subject to income taxes at some point in the future. If that inheritance takes place during the beneficiary’s peak earning years it could create a significant increase in taxes compared to what the original taxpayer would have paid even without any of the other factors being applicable.
Understanding what a person might pay in taxes now versus the future will have a big impact on whether specific tax planning strategies should be pursued. Any strategies that intentionally change the timing of income, whether that’s accelerating income through Roth conversions or capital gains harvesting, or accelerating deductions through tax-efficient charitable giving, need to be viewed through the lens of how tax rates might change over time. While these strategies may create new financial flexibility for the future, they may trigger higher taxes in a given year of retirement. (And, if you need more help with your financial plan, consider matching with a financial advisor.)
The idea that taxes will go down for everyone in retirement is a common myth that unfortunately leads to inaction on tax planning. The best way to avoid skyrocketing taxes in retirement is to have a proactive and intentional plan specific to your individual situation. Tax planning is about consistent action over time, not a one-time major event. Small hinges will swing big doors when it comes to reducing a person’s retirement tax bill. Steven Jarvis, CPA
After reading this information if you have areas of concerns or questions that I can help you address, please reach out. I'm here to help.