Retirement Step 9: How to Need Less Cash
Supposedly, retirement demands less income than you need in your working life. After all, once you've retired, you no longer have to pay Social Security or Medicare taxes (known as FICA taxes); you no longer divert money to 401(k)s or IRAs; and retirement income is often taxed at lower rates.
To see how all this works, let's consider a typical situation where a single person earns $80,000 a year and saves 10% of it for retirement. After deducting retirement contributions, FICA taxes, and income taxes, that typically leaves between $50,000 and $60,000 of spending money.
How much retirement income do you need in order to produce that same amount of after-tax spending power? That depends on where the income comes from. Here are some main sources of retirement income, and their tax consequences:
- Social Security: Depending on the amount of taxable income from other sources, anywhere between 0% and 85% of Social Security benefits can be taxed.
- Tax-deferred retirement accounts: Distributions from traditional IRAs, 401(k)s, 403(b)s, 457s, and thrift savings plans are taxed as ordinary income, at rates ranging from 10% to 35%.
- Investment income: Short-term capital gains (from investments held for one year or less) are taxed as ordinary income; long-term capital gains are taxed at either 0% or 15%. Dividends from most stocks held for 60 days are taxed at 0% or 15%.
- Roth retirement accounts: Qualified distributions from Roth IRAs, Roth 401(k)s, and Roth 403(b)s are tax-free.
Looking at various scenarios, we calculated that to replace what you take home of an $80,000 salary, you'd need to take between $55,000 and $62,000 out of your various sources of retirement funds. The more income you get from tax-favored sources like dividend income or Roth IRA withdrawals, the less you pay in tax -- and thus the less you have to pull out each year. If you take all your money from traditional IRAs and 401(k)s, you'll end up needing to withdraw more money before tax in order to have enough left after tax. That's because not only do you pay tax on what you take out of a traditional IRA or 401(k), but you also cause more of your Social Security income to be taxed as well.
Tips and takeaways
Here are a few lessons you can use:
- To maintain your pre-retirement standard of living in retirement, you'll need roughly 70% to 80% of your pre-retirement income. This is important to know, especially when using retirement calculators to crunch your numbers.
- The amount of income you'll need in retirement depends on your asset location. The more cash you have in tax-deferred assets, the more you'll need to withdraw to cover your living expenses, since a larger proportion of every distribution goes to Uncle Sam.
- Contributing to Roth and non-retirement taxable accounts comes at a price. The benefit of contributing to tax-deferred accounts while you're working is that you get a tax deduction when your tax bracket is higher. You lose that deduction if you contribute to a Roth or regular investment account. Technically, if you'll drop into a lower tax bracket in retirement, contributing to a traditional 401(k) or deductible IRA is the way to go. But (and this is a big but) this is only true if you take the tax savings from the deduction and save them for retirement.
In Step 10, we'll look at making the most of your retirement savings.