Financial FICTION #1: When You Retire, You’ll Be in a Lower Tax Bracket Because Your Total Income Will Be Lower Than It Was When You Were Working

Financial FICTION #1: When you retire, you’ll be in a lower tax bracket because your total income will be lower than it was when you were working.

As promised in my June 27 post, in the weeks ahead, I’ll dispel each of the 12 myths I identified in that post. I’m beginning today with the one which, in my opinion, happens to be the most critical and widespread.

Just like all the other myths on that list, this viewpoint sounds believable – even logical – doesn’t it? Unfortunately, though, it’s DEAD WRONG. This theory assumes that the income tax we pay is based solely on the income we earn. You see, under U.S. tax law, we pay taxes on the portion of our income that is taxable. The IRS calls that portion “taxable income,” because not all income is taxable. Just because Mr. A made $200,000 in a given year doesn’t mean that he’ll pay more in taxes than Ms. B, who made only $80,000 that year. That’s pretty interesting, isn’t it?

Let’s look at a hypothetical example:

Mary and her 10-year-old son, Shaun, live in Baltimore. Last year, from her $60,000 income she paid $9,600 in deductible mortgage interest and also made pre-tax contributions of $6,000 into her 401(k). To keep things very simple, let’s hold everything else constant as we look into Mary’s tax situation.

• Mary’s “total income” was $60,000. This amount will appear on line 22 of tax Form 1040. BUT the key here is that Mary (and everyone else in America) is not taxed on the $60,000. She gets to reduce that amount by her deductions and exemptions.    
• In this case, those deductions add up to $22,900 (the $6,000 in 401(k) contributions, plus, the $9,600 she paid in mortgage interest, plus, an exemption of $3,650 each for herself and Shaun, as her dependent).
• Therefore, Mary’s “taxable income” will be only $37,100 ($60,000 less the $22,900). That amount can be found on line 43 of Form 1040. In essence, that is the important number on everyone’s tax return – because that’s the number upon which our final tax payments are based.

This Whole Lower-Income Thing

Now we accept the argument that when Mary retires somewhere down the road, she’ll only need 80 percent of her current income, or $48,000 – but will that definitely lead to lower taxes? It had better. Otherwise, this whole lower-income theory falls apart. 

Let’s see what the numbers say.

Mary’s “total income” from line 22 of Form 1040 is $48,000. HOWEVER, just like most American retirees, her deductions and exemptions will be significantly diminished from when she was employed.

• First of all, she’ll no longer be funding her 401(k) – Mary’s now retired, so it’s harvest time instead.
• Secondly, Shaun will be a grown man and therefore “claim” his own exemption on his own Form 1040.
• What about Mary’s mortgage interest deduction? That’s gone too, because she paid off her house a few years back. In fact, that’s the very reason her financial advisor estimated that she’d need only 80 percent of her pre-retirement income.
• There’s some good news though: Mary still has her own personal exemption of $3,650, plus an additional $1,450 for being age 65 or older, as well as, another $5,800 standard deduction.

Now, please brace yourself for the kicker as we figure the portion of Mary’s $48,000 income that will be subject to income tax.

• From $48,000 we subtract $3,650, less $1,450, less $5,800, which equals $37,100. 

Do you realize Mary’s “taxable income” did not change by even a cent, in spite of the fact that her “total income” decreased by a whopping 20 percent? Perhaps you can now understand my choice of the word FICTION in the title to this post.

Ask Yourself a Few Questions

• Could you (comfortably) live the retirement lifestyle you desire on an income that is significantly lower?
• Have you ever wondered why most American retirees complain about being taxed up the wazoo?
• Does your financial advisor – or the person on whose advice you are planning your retirement – have real-life retired clients? If so, how are they doing, tax-wise? (Remember, just because you see someone on TV or hear them on the radio doesn’t mean they have real-life retired clients; more than likely, they may be using actors to run a show.)

_________________
Contact a financial professional at Laser Financial Group TODAY to begin a conversation about what will happen to your taxable income after you retire. 301.949.4449 or LaserFG.com