Taxes (federal, state, local, real-estate, Social Security, Medicare, etc.) are essential expenses that, unfortunately, must be planned for in retirement. As is the case with other expenses expected in retirement, we must make assumptions about how current tax expenses will change in the future to develop a reasonable estimate of the total present value of future household expenses (i.e., household spending liabilities), against which the total present value of household assets is compared. This post will address assumptions for projecting tax expenses using the Actuarial Financial Planner (AFP) and will include an example.
Our Actuarial Financial Planner (AFP) allows you to input different rates of future increases for up to three types of essential recurring expenses and up to two types of discretionary recurring expenses, in addition to separately accounting for various types of non-recurring expenses. So, if you believe that your future recurring medical expenses or your future taxes will increase at a faster rate than general assumed inflation, you can separately determine the actuarial reserve (present value) for those items utilizing higher annual future increase assumptions. And, if you believe that some or all of your future recurring discretionary expenses will not increase, or even decrease in retirement, you can model the financial impact of that assumed future. Finally, the AFP will automatically model desired spending on non-recurring expenses over the relevant assumed payment period (and not your entire period of retirement).
Federal (and often State) income taxes in the U.S. are generally based on household taxable income. Taxes on Social Security benefits and Medicare premiums are also based on household income (utilizing relatively complicated formulas that are not generally adjusted for inflation). Absent changes in tax laws, it may be reasonable to assume that current tax expenses will increase with assumed inflation (or somewhat higher) in the future if you expect household taxable income to approximately increase with inflation each year. Since many retirees have both taxable savings and tax-deferred savings and may defer commencement of Social Security benefits, pensions, annuities or distributions of pre-tax savings, it may be reasonable to assume that future tax expenses for retirees who defer taxes on these sources of income will increase significantly faster than increases in inflation.
If your household is deferring significant amounts of taxable income, we encourage you to estimate what your taxes would be today if expected deferred taxable income (in today’s dollars) were not being deferred. For example, what would your current taxes be today if expected household Social Security benefits were not being deferred and Required Minimum Distributions (RMDs) were being made from tax-deferred accounts in the current year? If your taxes would be much larger as a result, you should use a higher estimate for current taxes or higher-than-inflation assumed future increases to estimate the present value of your future essential tax expenses.
One relatively simple way to estimate a higher amount is to calculate the average of the current level of taxes for the number of years prior to deferral and higher levels of taxes for the remainder of the household lifetime planning period after commencement of the deferred taxable income. We will use an example to illustrate this approach.
Example
Bill is age 65 and is a single male retiree. His default lifetime planning period assumption is 29 years. He has a $45,000 per annum pension benefit that he is currently receiving, accumulated savings of $3,000,000 (with about half in after-tax accounts and half in tax-deferred accounts), and an estimated annual Social Security benefit payable at age 70 (in 2023 dollars) of 30,000 (85% of which we assume will be subject to income tax at age 70). He is currently using his after-tax account, pension and dividend and interest income to fund his current expenses until his Social Security commences. His current annual taxes, including real estate taxes total about $25,000. He is planning on deferring commencement of his Social Security benefit until age 70 and starting RMDs from his pre-tax accounts at age 73.
Bill estimates that at age 70 his federal and state taxes will increase by about $5,000 per annum to $30,000 as a result of commencing Social Security, and at age 73, his federal and state taxes will increase by another $13,000, to about $43,000, as a result of commencing RMDs from his pre-tax account. Bill estimates his average real dollar annual tax expense for his lifetime planning period to be $38,552, determined as follows:
[($25,000 X 5 yrs. prior to age 70) + ($30,000 X 3 yrs. From age 70 to age 72) + ($43,000 X 21 yrs. after age 72)] / 29 yrs. = $38,552 average per year
Bill enters this amount for estimated taxes in this year’s AFP rather than his current taxes of about $25,000 and assumes this average amount will increase by inflation plus 0.5% each year. In future years, he will re-estimate this amount based on future tax laws and his changing personal situation.
Summary
In order to properly balance household assets with household spending liabilities, it is important to develop a reasonable estimate of the present value of future household expenses, including tax expenses. Because commencement of taxable income can be deferred, it may be necessary to input a higher average annual tax expense or a larger-than-inflation assumed increase rate rather than simply assume that current relatively low taxes will remain relatively constant in real-dollar terms from year to year.
