We get a lot of questions from people wondering how their taxes will change once they hit retirement. While there’s no “one size fits all” when it comes to tax-related issues, it’s important to understand the basics of your working effective tax rate vs. your retirement effective tax rate.
Working Effective Tax Rate
If you are currently working, do you know how much you really pay in taxes? Remember, this is the total of all your taxes including income, capital gains, property, and sales taxes. Most people I ask tell me they pay about 30 percent. That may sound high, but it turns out to be right.
When I gauge a clients’ approximate overall effective tax rate, I often go the bankrate.com tax calculator. You may be surprised to see how low your “effective” federal tax rate is, but remember, this is not your actual tax rate. Many tax calculators calculate only your federal tax rate and don’t show all the areas that take a sizeable bite out of your paycheck such as FICA and state income taxes.
To understand how this works, let’s look at an example:
The Smiths live in Georgia and earn $110,000 a year. Although their overall effective tax rate is only about 15 percent, the bankrate.com tax calculator more accurately indicates their tax bracket is 25 percent. That’s because our tax system is progressive; you pay a higher percentage on your earnings as they go up and pass certain thresholds.
While 15 percent seems pretty manageable, keep in mind that the Smiths are still working. They are still earning a wage which means that 15 percent is going to quickly increase due to all of the other taxes we haven’t yet added in.
First up, enter in FICA. FICA is the 1935 Federal Insurance Contributions Act that established the tax-funded Social Security. For 2015, the FICA tax is 6.2 percent on the first $118,500, a 1.28 percent hike over the 2014 wage base of $117,000. So for the Smiths, making $110,000 and in the 25 percent bracket, we have to factor in an additional 6.2 percent tax burden. On top of that, we pay another 1.45 percent tax on everything we earn for Medicare. And last but not least, using my home state of Georgia as an example, I now need to add in another 6 percent income tax.
Now for the math:
To illustrate just how quickly how quickly our taxes add up, let’s do some simple math:
15% (Federal tax) + 6.2% (FICA) + 1.45 (Medicare) + 6% (Income tax) = 28.65%
This number means that 28.65 cents of every dollar that the Joneses earn go towards taxes. That’s nearly one-third!
Retirement Effective Tax Rate
In the above example, the Smiths are still working and earning a wage. The bulk of their income is from their jobs and taxed at ordinary income rates. But what happens when they retire? Remember that original 15 percent effective tax rate? Now that number may actually be representative of what they would pay overall. Luckily, retirees typically get to stop paying Social Security taxes, Medicare taxes, and in many places around the country, they get a break on state and local taxes too.
Don’t forget that the Smiths 15 percent effective tax rate was based upon their earnings of $110,000 a year. It’s most likely their income will be lower once they enter retirement, which can also bring down their effective tax rate. Additional good news is that if you’ve had your Roth account for at least five years and you’re over the age of 59 ½, withdrawals will be tax-free, as will accessing the principal from savings and investments. Long term capital gains are taxed at lower rates or can even reduce your other taxes if you’re selling at a loss.
Amidst this comforting news, just keep in mind that taxes are tricky and no one is ever completely out of the woods. You’ll still be taxed on pension income, any rental, business, and wage income you have, and withdrawals from taxable retirement accounts. Social Security is taxed at ordinary income rates but luckily only part of it is taxable.
Are you interested in learning more how your tax rate is going to change once you move into retirement? The best piece of advice I can give you is to go see a CPA who can do a tax projection for you. Taxes are a complex issue and it’s best to get your advice from a trustworthy professional.
About the author: Wes Moss is the host of the Money Matters radio show on WSB Radio, host of the TV show Atlanta Tech Edge on Atlanta’s NBC affiliate, and Chief Investment Strategist at Capital Investment Advisors. In 2014, he was named one of America’s top 1,200 financial advisors by Barron’s Magazine. He is the author of several books including his most recent, You Can Retire Sooner Than You Think - The 5 Money Secrets of the Happiest Retirees, which was one of Amazon’s best-selling retirement books in 2014. Contact him at [email protected], @WesMoss365, or Facebook.com/wesmossmoneymatters.