Retirement planning can be tough. After all, the future is an abstract place where it can be difficult to grasp the details, and life is full of unexpected turns. We can make our best assumptions, but it’s difficult to know how much money we need and how long we will live in retirement. While we tend to focus on housing, transportation, food, entertainment, and travel costs there are 3 hidden and underestimated expenses that people overlook all of the time.
Taxes are likely to be a big expense in retirement, and many people don’t understand how their retirement income will be taxed.
While payroll taxes (Social Security and Medicare) will drop off and do not apply to retirement income (unless you continue to work and earn wages), federal and state income taxes do. That is, unless you live in one of the seven states with no personal income taxes (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming).
Let’s take a look at how some of the most common sources of retirement income may be taxed.
Most pensions are taxable as part of your ordinary income. For federal employees, FERS and CSRS are no different, they are mostly taxable allowing only for your contributions to be returned tax-free as part of your monthly retirement payment. The portion that was contributed by your agency, which generally accounts for 90% or more of your retirement payment, is fully taxable.
The majority of people rely on social security as some part of their retirement income. I’ve found that many people don’t believe their social security income is taxed. However, in most cases, it is. The IRS rules on the taxability of social security income are as follow:
If you are filing as an ‘individual’ and your income is between $25,000 and $34,000, you may have to pay tax on 50% of your benefits. If you make more than $34,000 up to 85% of your benefits may be taxable.
If you are filing a joint return and your income is between $32,000 and $44,000, you may have to pay taxes on 50% of your benefits. If you make more than $44,000, up to 85% of your benefit may be taxable.
Most employer sponsored retirement accounts are tax-deferred, this includes your TSP, 401(k), 403(b), and IRA accounts. Since most contributions receive tax deductions and employer contributions have never been taxed, when you start taking distributions from these accounts to supplement retirement income, they are usually fully taxable.
The exceptions to this are Roth TSP, Roth 401(k), or Roth IRA account balances and IRA or employer sponsored plans that have a non-taxable basis. Roth accounts receive after-tax contributions, they grow tax-free over time, and qualifying distributions are tax-free. Traditional plans that have a non-taxable basis have received non-deductible contributions at some point and that portion of the account will not be taxed again upon distribution. With recent changes in legislation under the SECURE Act, there are some interesting tax-planning opportunities to look at here, in particular Roth conversion strategies.
There are also handful of other nuisance taxes that apply, the most prominent are property taxes, including:
Real estate property taxes vary widely by state and locality. According to the U.S. Census Bureau the average effective property tax rate across the United States is 1.05%. While they can be expensive depending on your property value, real estate taxes are used by municipalities to support the communities where we live in many different ways.
Vehicle personal property taxes are one of the more frustrating taxes in existence. There are currently 27 states that levy annual personal property taxes on your vehicle(s) and these rates vary widely as well. A newer vehicle with a higher assessed value can carry a hefty tax bill. You can research your county/locality tax rate by reviewing your bill or locating the county’s website for more information.
Insurance, like taxes, is another recurring expense that just doesn’t go away and continues in various forms throughout retirement. Health insurance, pension survivor benefits, life insurance, long-term care insurance, as well as home, auto and umbrella liability coverages are all important considerations for many to protect their families.
Health insurance premiums
In most cases you’ll need to coordinate health insurance until at least age 65 when you become eligible for Medicare coverage. It will be important to evaluate the options at that point, especially if you are a federal employee.
Fortunately, as a federal employee your health insurance premiums will not increase in retirement and will remain at the same rates as an active employee, however your premiums will be paid with after-tax dollars.
In the private sector health insurance premiums tend to rise for retirees, sometimes dramatically, making this a potentially large expense until Medicare kicks in.
Pension survivor benefit cost
Protecting pension income for a spouse can be accomplished by electing a survivor benefit option when claiming benefits. However, like any other type of protection or insurance, survivor benefits come with a price that varies based on the plan.
With a CSRS or FERS pension the full survivor benefit is 50% of the PIA, and the premium cost is 10% of the PIA. This expense is pre-tax for annuitants. It’s also important to note that a survivor benefit of some level is required to be elected for your spouse to maintain FEHB coverage if you predecease them. Likewise, the military retirement pension has a survivor benefit option that comes with a premium of 6.5% of the annuity amount elected for a survivor.
Life insurance and long-term care premiums
Carrying life insurance in retirement can be useful in a number of ways - legacy & estate planning, charitable giving strategies, protecting income, and providing tax-free cash flow and liquidity. It’s often believed that there isn’t a need for life insurance after you reach retirement, but in many situations it remains important. Premiums vary based on the type and amount of insurance called for.
In similar fashion, long-term care insurance can help pay for care if needed and protect the assets you’ve built over a lifetime. This industry is changing fast, including large premium increases on traditional policies and the innovation of combination products (life and long-term care insurance together, etc.). Make sure to do your homework as it can be confusing and expensive.
Home, auto, and umbrella liability premiums
Home and auto coverage may speak for themselves, but don’t forget about your umbrella liability policy. If there is an accident where you are deemed responsible, this coverage will extend after your other liability coverage is exhausted making it invaluable in protecting your assets if something unexpected happens. Umbrella liability coverage is usually relatively inexpensive.
Last on the list is inflation. This one is sneaky. Price increases happen so gradually that it’s hard to detect until you look at the changing numbers over time. You can certainly see the changes when you look back over a period of a few years at what we used to pay for various goods and services. I always like to take a look at new vehicle prices from years ago, there you can truly see the impact, for example a 1965 Chevrolet Corvette had a base price of $4,106. What’s most important to look at is inflation on the items that you don’t have a choice over - fixed expenses. You can use this CPI inflation calculator from the BLS for a look at historical CPI rates..
How do you plan for rising prices? The best way is by making investment choices that support your goals and income needs while at the same time reflecting your risk tolerance. With the low interest rate environment of the past 15-20 years traditional conservative options have come with their own risk - CD’s and savings accounts that may yield less than inflation will erode purchasing power. Creating an investment mix and positioning your assets to keep up with and outpace inflation can help you maintain your purchasing power and standard of living.
Remember, retirement planning is a work in progress and even the best laid plans will be wrong in some way because life is unpredictable. Understanding what to expect with proper planning and preparation can help you to be successful and make needed adjustments along the way.
If you’d like to learn more about my firm and retirement planning, please send us a message.
*The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material. This article is intended to assist in educating you about insurance generally and not to provide personal service. They may not take into account your personal characteristics such as budget, assets, risk tolerance, family situation or activities which may affect the type of insurance that would be right for you. Guarantees are based on the claims paying ability of the issuing company.