What is your largest expense in retirement? Is it the one you thought it would be?
Our newsletter editor brought to our attention a survey done by the Spectrem Group in August 2008 for retirees age 70-75 who have about $1 million in net worth (excluding their primary residence). The results of this survey may, or may not, surprise you. However, the results should certainly cause you to reconsider your plans during your retirement years.
Did you think that healthcare would represent your largest expenditure? We certainly hear a lot about the cost of healthcare. Healthcare expenses are 10th on the Spectrem Group list.
As a matter of fact, income taxes are the number one expenditure. And it isn’t even close: Personal income taxes represent an expense that is twice the amount of the second-largest category, vacation/leisure travel.
Like many of our clients, the people in the survey receive the largest portion of their income from their IRAs. This income is taxed as ordinary income when it’s taken from a traditional IRA in retirement. This is not a bad thing. After all, the reason you put the money into your IRA was to defer taxes. When you retire, you pay taxes on your withdrawals.
How large is the typical tax obligation? You can plan (at least for the present) on being in the 25% federal marginal tax bracket. In addition, most states have taxes on income. Maryland is high at around 8%; Arizona is much less, around 4.5%.
The effective tax rate, or average tax rate, is the amount of tax you pay on each dollar of income. A Maryland resident would probably face an average combined state and federal tax burden of 20 to 25%.
Typically, our clients tell us that they need about $60,000 from their IRA each year to pay for their living expenses. That means they have a tax obligation of $12,000 to $15,000, on top of their living expenses.
The substantial tax obligation gives rise to a need for solutions. BWFA’s tax department and financial planners consider the unique circumstances of each client and then make actionable recommendations. BWFA recommends the following:
- A strategy that provides a “retirement paycheck” that minimizes taxes. We use a combination of distributions from taxable and retirement accounts. We also find unique opportunities in our annual planning reviews, such as Roth IRA conversions.
- The amount of taxes to withhold from your “retirement paycheck.” This is tricky. Our clients tell us how much they need to live on, and we calculate the taxes due. The more taxes we add, the larger the distribution must be. Do you see the circular logic?
- The best source of money to fund extraordinary purchases such as a car, a cruise, gifts to college funding, etc.
For each client’s unique situation, BWFA’s tax department looks for tax-efficient ways of making withdrawals and meeting annual income goals.
The bottom line is that you need to plan for the payment of your largest expense in retirement. And we can help.