Due to some ambiguously provocative statements from a few celebrities and professional athletes, there has been a revival of “flat earth” theories in public discussion. In one form or another, these ideas postulate that the Earth is not a sphere, but a flat disc that bends on itself.
Even though there is strong evidence to discredit them, flat earth theories persist because they align with our perception that the Earth is flat. So when a “new” version of flat earth comes along, it’s easy for us to say, “Well, you know…that sort of makes sense”—even though this iteration isn’t much different than others that have been discredited.
The “Flat Earth” Statement of Retirement Planning
Similarly flawed theories exist in personal finance. Despite facts to the contrary, these ideas persist because, at first hearing, they sort of make sense. For example, there’s this one, which first appeared in the mid-1970s, with the introduction of the individual retirement account (IRA):
“You’ll be in a lower tax bracket in retirement.”
Sounds like it ought to be true, right? A primary motivation for making tax-deferred contributions today is the belief that the taxes due when the funds are withdrawn will be less than the deduction received on the deposits.
When IRAs (and their employer-sponsored cousins, like 401(k)s and 403(b)s) first appeared, no one really knew if “You’ll be in a lower tax bracket” was true. But after 40-plus years, enough individuals who saved in qualified retirement accounts have transitioned to retirement to arrive at a definitive conclusion: Those who do a good job saving during their working years will most likely not be in a lower tax bracket in retirement.
What the Numbers Say
In November 2018, The Nationwide Retirement Institute released findings from a “Tax and Retirement Income Survey,” based on data collected by The Harris Poll. The respondents came from three groups: those retired for more than 10 years, those retired for 10 years or less and those who expected to retire in the next 10 years.
Each group was asked to assess their tax rate in the first five years of retirement compared to either their current tax rate if still working, or their tax rate in the five years prior to retirement. Across the board, three out of five respondents said their tax rates were either about the same or higher in retirement. Here are the exact percentages:
Retired for 10 or more years: 59%
Retired for 10 years or less: 58%
Planning to retire within 10 years: 61%
Why might this be? Well, consistent savers most likely have other good financial habits. They systematically reduce or eliminate debt, and live within their means. By the time they retire, these households have accumulated enough money to continue living as they did when they were working. And there aren’t any compelling reasons to further delay gratification or decrease lifestyle just to stay in a lower tax bracket. Realistically, the only retirees who can anticipate a lower tax bracket are those who didn’t save enough while they were working.
Another possible reason many retirees find themselves at the same level of taxation or higher: They ignored the distribution aspect of retirement planning. Believing the lower-tax-bracket-in-retirement mantra to be accurate, savers sought retirement plans offering up-front deductions, assuming whatever taxes to be assessed at distribution would be less.
In hindsight, many retirees recognize they should have given taxes a closer look. The survey found that only 25% of older retirees (those who had been retired for more than 10 years) considered themselves knowledgeable or very knowledgeable about how their retirement income was impacted by taxes. The numbers for the other cohorts were slightly higher, but across all groups, there was an expressed need for better tax planning.
These comments highlight a critical nugget of financial wisdom: Taxes at distribution can make two accounts with the same balance spend differently. For example, the true after-tax cost of a bucket-list trip to Europe could be $20,000 or $25,000, depending on which account is used to pay for the trip.
Eric Henderson, a Nationwide executive, points to the disproportionate public emphasis on accumulation as telling only half the retirement planning story: “It is also important to determine how to spend your retirement income. Building tax flexibility into a retirement income plan is crucial. Doing so allows you to use different types of investments and retirement accounts (taxable, tax-deferred and tax free) to potentially avoid higher tax brackets.”
Flat Earth Theories Persist, but That Doesn’t Make Them True
With 60% of retirees finding they aren’t in a lower tax bracket, it’s perhaps prudent to retire the idea of “You’ll be in a lower tax bracket,” or at least be a bit skeptical about the claim. Yet just like the persistence of flat earth theories, some in the financial service industry continue to exhort consumers to maximize contributions to a qualified retirement plan.
Saving is a good thing, but so is tax flexibility.
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This article was prepared by an independent third party. Material discussed is meant for general informational purposes only and is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon only when coordinated with individual professional advice.
Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS), 355 Lexington Avenue, 9 Fl., New York, NY 10017, 212-541-8800. Securities products and advisory services offered through PAS, member FINRA, SIPC. This firm is an agency of The Guardian Life Insurance Company of America® (Guardian), New York, NY. PAS is an indirect, wholly owned subsidiary of Guardian. Wealth Advisory Group LLC is not an affiliate or subsidiary of PAS or Guardian. Wealth Advisory Group LLC is not registered in any state or with the U.S. Securities and Exchange Commission as a Registered Investment Advisor. Neither Guardian, PAS, Wealth Advisory Group, their affiliates/subsidiaries, nor their representatives render tax or legal advice. Please consult your own independent CPA/accountant/tax adviser and/or your attorney for advice concerning your particular circumstances.
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Submitted by Elozor M. Preil