One of the first essential items of “pre-retirement” planning is to discover your effective tax bracket in retirement. Tax management is a significant strategy to create increased cash flow without market risk. It’s impossible to appreciate the tax equivalent return of any investment until you know your effective tax bracket. And you can’t measure the economic impact of ERISA retirement plans without this knowledge either. The U.S. tax code is a marginal, “progressive” income tax system. As your income increases or “progresses” from one tax bracket to the next you pay a blended tax rate of each tier, after all your tax deductions and exemptions (providing they’re not phased out) as well as any tax credits to reduce taxes owed. Once you know your effective tax bracket you can determine the value of a financial product, especially tax favored financial products and ERISA retirement plans.
A Roth IRA is an alternative to tax deductible defined benefit and defined contribution plans. Roth IRAs can’t be deducted, but their proceeds are tax-free during conventional retirement years. So, is the tax deduction worth your participation in a 401(k) strictly on the tax savings? (You do want to participate in a 401(k) if the employer is matching part of your contribution.)
Sticking with the example of a 401(k) plan… is your tax deduction, in your effective tax bracket, worth taking? Keep in mind that by taking the deduction you’re giving up its tax-free basis, i.e. your original contributions. Your 401(k) plan will be taxed at ordinary income tax rates and be included in the provisional income test for Social Security benefit taxation. If you’re not in a high effective tax bracket today, you may be setting yourself up to pay higher taxes in retirement, just when you need your money the most.
Managing your taxes could reduce your income a tax bracket or two. Your stated tax goal is not to bump yourself into the next highest tax bracket. This is a real concern for Roth IRA conversions from qualified plans. The economics of converting qualified plans to Roth IRAs needs to be determined and validated for its economic impact. You can’t just undergo a qualified plan conversion to a Roth IRA for its future tax impact; it also has to have a present day value. The goal is to convert your qualified plan to a Roth IRA without bumping you into another bracket. Roth Strategies can be very useful in managing retire income with some tax efficiencies.