Retirement planning can be tough, the future is abstract and it's difficult to envision the details. We can make our best assumptions, but it’s difficult to know how much money we need and how long we'll live in retirement. While most of the focus is on housing, transportation, food, entertainment and travel, there are 3 hidden expenses that are often overlooked.
Taxes will likely be a big expense in retirement, and it's important to understand how your 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. There are seven states with no personal income taxes (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming).
How are some common sources of retirement income taxed?
Most pensions are taxable as part of your ordinary income. For federal employees, FERS and CSRS are taxable allowing only for your contributions to be returned tax-free as part of your monthly retirement payment. The portion contributed by your agency, generally accounting for 90% or more of your retirement payment, is fully taxable.
Most people rely on social security for part of their retirement income. While many people don’t think their social security income is taxed, it most likely is. The IRS rules on the taxability of social security income are:
If you file 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 file 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, distributions from these accounts are usually fully taxable.
The exceptions is 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 with a non-taxable basis have received non-deductible contributions and that portion of the account will not be taxed again upon distribution. Recent changes in legislation under the SECURE Act, have created some interesting tax-planning opportunities to consider, including Roth conversion strategies.
There are also a handful of 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 community in many different ways.
Vehicle personal property taxes are one of the more frustrating taxes that exist. 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 high 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 is a recurring expense that 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 important considerations.
Health insurance premiums
In most cases you’ll need to coordinate health insurance until age 65 when you become eligible for Medicare. It will be important to evaluate the options at that point, especially if you are a federal employee.
Federal employee 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, 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. Like any type of 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 PIA, and the premium cost is 10% of the PIA. This expense is pre-tax for annuitants. It’s important to note that a survivor benefit is required 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
Life insurance can be useful in a number of ways - legacy & estate planning, charitable giving, 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.
Similarly, long-term care insurance can help pay for care and protect the assets you’ve built over a lifetime. This industry is changing fast, including premium increases on traditional policies and the innovation of combination products. 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 responsible, this coverage will extend beyond other liability coverage making it valuable to protect your assets if something unexpected happens. Umbrella liability coverage is usually relatively inexpensive.
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 it when you look back over a period of a few years to what we used to pay for goods and services. I like to look at new vehicle prices, 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 needs while reflecting your risk tolerance. Low interest rates have led to inflation risk with traditionally conservative options - CD’s and savings accounts that may yield less than inflation will erode purchasing power. Creating an investment mix to keep up with and outpace inflation can help maintain purchasing power and standard of living.
Retirement planning is a work in progress. Understanding what to expect can help you to make adjustments along the way.
If you’d like to discuss your plan please reach out.
*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.