For those who are still working, calculating how much income will be needed to support a certain retirement lifestyle is a key variable in the financial planning process and a tricky problem to solve.
For decades, researchers have developed rules of thumb to help prospective retirees arrive at a solution with less effort. In last week’s article we introduced one of the most relied upon of these metrics, the income replacement ratio.
The IRR addresses the question “How much income will I need once I retire to maintain my standard of living?” The answer, according to many retirement researchers and public policy experts, is between 70 percent and 90 percent of pre-retirement income. Using the lower end of the range, a household earning $100,000 in the year before retirement would aim for $70,000 per year to support living expenses after retirement. In large part, target replacement rates of less than 100 percent are considered adequate because taxes, spending needs and the requirement to save are all assumed to decline in retirement.
Although this is a reasonable starting point, blind adherence to this “one size fits all” recommendation is ill-advised. To arrive at an optimal estimate of income needed in retirement, future retirees should first examine the reliability of the underlying assumptions when applied to their particular circumstances and then take a hard look at what could go wrong from there. Let’s start with taxes.
Tax rate assumptions significantly impact the target IRR. Specifically, higher future tax rates would translate into a higher IRR while lower rates would result in a lower IRR. The expectation that taxes will decline in retirement is reasonable but by no means assured. It is true that when individuals leave the workforce they no longer pay the 7.65 percent FICA taxes on wages, and for most retirees a smaller income puts them in a lower tax bracket.
In addition, Social Security benefits are taxed more favorably than wages. On the other hand, there are a few good reasons to question the theory that retirees will face appreciably lower tax bills than they did while working. First marginal rates are at historically low levels across all income brackets, while our national debt stands at a historic high of over $17 trillion. It is certainly plausible that higher taxes will be at least part of the solution to our country’s fiscal problems.
Second, while salaries disappear when an individual exits the workforce, so do valuable tax breaks in the form of deductible contributions to employer retirement plans and IRAs. Investment earnings from taxable accounts and withdrawals from retirement plans to pay for living expenses and meet IRS minimum distribution requirements will, therefore, be taxed without the benefit of offsetting deductions to soften the blow.
Finally, affluent retirees are likely to face higher taxes on Social Security benefits as policymakers struggle with restoring financial stability to the program. These are just a few scenarios that could undermine the premise that retirees will pay lower taxes.
The point is that it is difficult to predict what tax rates will be in the future so building a retirement plan on the expectation of lower taxes could prove risky.
Next week we’ll explore the spending assumptions used to calculate the income replacement ratio.
John Spoto is the founder of Sentry Financial Planning in Andover and Peabody (New Location). For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com.
This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.