Given the various ways in which retirement resources might be taxed, it is important to consider that the potential tax liability could account for a significant share of retirement assets, according to a new study.
In fact, households in the aggregate will have to pay about 6% of their income in federal and state income taxes, but this liability can rise significantly for those in the top quintile of the income distribution, Anqi Chen and Alicia Munnell of the Center for Retirement Research at Boston College explain in “How Much Taxes Will Retirees Owe on Their Retirement Income?”
To evaluate their retirement resources, households approaching retirement typically will examine their Social Security statements, defined benefit and defined contribution balances, and other financial assets, yet many forget to factor in the state and federal taxes that may need to pay on these resources, Chen and Munnell observe.
To get a better understanding of just how large the tax burden is for the typical retired household at different income levels, the researchers estimate lifetime taxes for a group of recently retired households. Using data from the Health and Retirement Study linked to administrative earnings to determine Social Security benefits and administrative records on state of residence, they estimate state tax liabilities. They then project income over the expected retirement of each household, and estimate federal and state taxes with NBER’s TAXSIM program for each household on its reported and projected income.
For the lowest four quintiles, Chen and Munnell find that taxes are negligible. Regardless of the drawdown strategy, households in the bottom three average indexed monthly earnings (AIME) quintiles most likely pay zero taxes in retirement. And this percentage rises to only between 2% to 3% for the fourth quintile. “In terms of financial security in retirement, this finding is good news—most households are not dramatically underestimating the resources available in retirement by not considering taxes,” Chen and Munnell emphasize.
In contrast, taxes are significant for the top quintile, so it is important to consider the economic circumstances of these households. They note, for example, that the average liability is 11.3% for the top quintile, 16.4% for the top 5%, and 22.7% for the top 1%. These are mostly married couples with average combined Social Security benefits of $50,900, 401(k)/IRA balances of $325,400 and financial wealth of $441,400, the study notes.
If these retirement and financial assets were fully annuitized, the amount a household would receive is equivalent to about $3,000 a month. “These households as a group are not what many would consider wealthy. The fact that they constitute the highest quintile highlights the fact that most households do not have a lot of money in retirement,” Chen and Munnell observe.
Yet, they note that this group will pay about 11% (or 12% to 13% for other drawdown scenarios) of their retirement income in taxes. “Given that, without considering taxes, about 40% of households in the top third of the income distribution are at risk of not being able to maintain their standard of living, taxes will make the goal even more difficult to attain,” according to the authors.
A final observation of the study is that the drawdown strategy does not appear to have much impact on the tax rate. Chen and Munnell note that, for those in the top quintile, effective taxes range from 11.3% to 12.8%. Those in the top 5% and top 1% are subject to a 16.4% to 17.9% or 22.7% to 25% tax rate, respectively, depending on drawdown strategy.
