When retirees look at all their sources of retirement income, including Social Security benefits, 401(k) plans, pensions, savings and other investments, they need to keep in mind: Some of that will go to the government in taxes.
To shed light on the tax burdens retirees face, researchers Anqi Chen and Alicia H. Munnell of the Center for Retirement Research at Boston College estimated lifetime federal taxes for a group of recent retirees in a paper presented at the Retirement and Disability Research Consortium 22nd Annual Meeting symposium in early August.
The researchers looked at households in which at least one earner claimed Social Security benefits between 2010 and 2018, which produced a sample of 3,419 individuals and 1,907 households. Average indexed monthly earnings are used to calculate Social Security earnings.
Here are some highlights from the findings, which the researchers warned were “preliminary and partial.”
How much retirement money does the average household have?
Researchers totaled the financial resources available to the households in their first year of retirement. They divided the households into quintiles, from the bottom quintile, which had less than $20,000 from all potential revenue streams — Social Security, defined benefit pensions, defined contribution plans like 401(k)s, and financial wealth — to the top quintile, which averaged $323,000. The top 1% had roughly $1.7 million in retirement resources.
The Researchers’ Assumptions
The researchers assumed that households wouldn’t draw from their 401(k)s or IRAs until required to do so and would follow required minimum distribution rules.
Here, researchers saw two alternative decumulation strategies. First, they looked at households that began withdrawing before they were required to. But they assumed withdrawals at the rate implied by the RMD rules.
Another alternative they considered was using 401(k)/IRA balances at Social Security claiming age to purchase an immediate annuity.
Finally, the researchers assumed that households with assets “outside of these retirement arrangements” used only interest and dividends to support their retirement, or used their assets (paying taxes on accrued capital gains) to buy an annuity while claiming their Social Security benefits.
What’s the average federal tax rate for retirees?
This chart is based on the option of households taking only RMDs and living off the interest and dividends of financial assets. On average, the tax rate is 5.7%; however, it differs greatly by income level.
Those in the bottom three quintiles pay 0% or 0.3% in federal taxes while those at the top quintile are paying an average of 10.5%. The top 1% are paying federal taxes at an average rate of 20.9%.
For those married with higher income, annuitized DC plan assets can make a difference in taxes.
If a household annuitizes its 401(k) balances as well as 50% of its other financial wealth, taxes for all groups, except those one percenters who are married, go up almost by 1%. Overall, it rises to 6.5% (versus 5.7%). Singles as a whole would pay an average of 8% (versus 6.5%) and those married would pay 6% (versus 5.4%).
Married couples in the top 1% see their tax rate drop to 19.1% from 21.0%.
In the highest tax rate quintile, the study states, it’s “important to consider the economic circumstances.” They are more likely than less affluent households to be married, with average combined Social Security benefits of $33,130, 401(k)/IRA balances of $180,790 and financial wealth of $87,500.
The researchers note that these people would not normally be considered wealthy, but that “most households do not have a lot of money in retirement.”
Why taxes in retirement matter.
The study points out that even without considering taxes, “40% of households in the top third of the income distribution are at risk of not being able to maintain their standard of living [in retirement].” So taxes do make a difference, especially for those in higher income brackets.
That said, the decumulation strategies in the study did not yield much difference in tax rates. Further, this study did not include state taxes, which could raise tax burdens by 25%.
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