MAKING SENSE -- September 21, 2012 at 10:18 AM ET
A Look at Taxes and Retirement Savings
Photo by: Kick Images via Getty Images
Paul Solman frequently answers questions from the NewsHour audience on business and economic news on his Making Sen$e page. Today's query is from a reader at Next Avenue. The NewsHour has partnered with Next Avenue, a new PBS website that offers articles, blogs and other critical information for adults over 50.
Angie Stehr: Calculations I see for retirement planning all seem to be based on income rather than expenses. But if I'm saving 20 percent for retirement, shouldn't I base my planning on 80 percent of my current income (even assuming my expenses are the same)? And do I base it on gross income or adjusted income? My current paycheck deducts Social Security and FICA -- when do I stop paying those? Exactly what part of my income should I be trying to replace? It doesn't seem like I should need to replace those portions of income that go to retirement (a significant percentage for us: we really do sock away more than 20 percent per year).
Paul Solman: Yes. The traditional rule-of-thumb is to save enough so you can spend 80-85 percent of your pre-retirement after-tax income once you stop working. But be careful, now: I'm also referring to after-tax income in retirement.
Let's assume your household is right at the national median: $50,000 a year. Taking you at your word, you've been saving something above 20 percent a year so let's make it $12,000. That means you would have been living on $38,000. Further assume, as I do, that your out-of-pocket expenses won't go down in retirement. Yes, you may not ever have to buy another piece of furniture, but you'll have more time to travel. For my own planning purposes, I figure it will all more or less even out.
So: you need to generate $38,000 a year, after tax. But that may mean a yearly "income" of more than $38,000 a year. That's because, if your retirement money is mainly invested in a tax-deferred IRA or 401(k), it will be subject to taxes when you withdraw it. That's what "tax-deferred" means. Same thing for Social Security benefits, by the way: if your annual household income exceeds $32,000, you'll be taxed on as much as half of it. Beyond $44,000? Eighty-five percent of your Social Security income may be taxable. (The tax on Social Security income stops at 85 percent of your benefits.)
You get the idea, I trust. You'll need something like $38,000 a year, which means income in the $40,000s, including Social Security.
Here's a final heretical thought, though. Might you just possibly be saving too much? Quite possibly, thinks our Social Security guru, Larry Kotlikoff, whose posts have drawn more than 600,000 views since he first appeared here on July 30. Not that Larry, who's in Budapest today, has seen your email. But he's long warned that investment firms who profit from managing your money frighten many people into building too big a cushion and therefore depriving themselves in their prime. Here's a solid summation of Larry's and related work from Dan Kadlec at TIME magazine's "MONEYLAND" blog.
As usual, look for a second post early this afternoon. But please don't blame us if events or technology make that impossible. Meanwhile, let it be known that this entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions.