One of the biggest reasons i He was Against contributing to a Roth IRA is my belief that most people will not earn more money in retirement than they do while working. As a result, they are less likely to pay a higher tax rate in retirement than in their working years.
This belief also assumes that tax rates will remain stable. Since 2009, when I first shared my views on Fiscal Samurai, tax rates have generally trended lower. Just as cutting Social Security benefits constitutes political self-harm, campaigning to raise taxes is not a winning strategy for politicians seeking power.
Earning more money in retirement than in your working years takes effort, discipline, consistency, and a little good luck. Given the current state of personal finance in America — which is not great — this scenario is unlikely for most people.
Intuitively, many people understand this. However, let’s delve into the numbers to get a clearer picture. I’ll also explore why some of us may end up making more in retirement than they did while working. One key is to understand the concept of deferred income and how it is taxed.
Why do most people earn less in retirement?
If we look at the average and median net worth of retirees, it is reasonable to conclude that most Americans will earn more while working than they will when they retire.
- The average household income in the United States is about $80,000.
- The average per capita income is about $43,000.
Now, consider the average net worth of $192,000 (based on the most recent Consumer Finance Survey). Using the 4% rule, a safe withdrawal rate, this net worth generates just $7,680 per year.
Fortunately, Social Security provides Average pay is $22,333 per yearAnd it rises with the inflation index every year. Adding these items together gives retirees a total income of $30,013 per year.
Compare this to the average per capita income of $43,000. $30,013 is about 30% less. The average net worth would have to be at least $325,000 higher, or more than $517,000, for the typical retiree to make more in retirement.
On the bright side, retirees earning $30,013 a year don’t need to worry as much about taxes because of the standard deduction and lower marginal tax rates at that income level. I estimate that individuals can accumulate up to $1.5 million from an investment portfolio and still not have to pay much, if any, taxes in retirement.
WhyYou You may earn more in retirement than you do while working
While most Americans earn less in retirement, You’re not most people. You’re subscribed to the free Financial Samurai newsletter and you’re obsessed with money and living an amazing life!
Readers of personal finance sites like this one likely save much more and invest more strategically than the average individual. We are an obsessive bunch who care a lot about our financial future.
Thanks to the power of compounding, decades of disciplined saving and investing can result in you earning much more in retirement than you ever expected.
Compound strength
Let us illustrate the amazing potential of the compound. Let’s say you invested $100,000 and got an annual return of 10%. Example assumes No additional contributions After an initial investment of $100,000. Here’s how your wealth grows over time:
- Year 1: $100,000 → $110,000
- Year 10: $100,000 → ~ $259,000
- Year 20: $100,000 → ~ $672,000
- Year 30: $100,000 → ~ $1.74 million
- Year 40: $100,000 → ~ $4.52 million
- Year 50: $100,000 → ~ $11.74 million
It may take 30 years to reach your first million, but by year 50, doubling adds millions annually to your portfolio. Starting early and staying invested is key to building significant wealth.
Why are withdrawals considered income?
Another reason you may earn more in retirement is the tax treatment of withdrawals. This point didn’t quite occur to me until I spoke with Bill Bengen, creator of the 4% rule, and after I wrote another article about minimizing taxes when withdrawing from retirement portfolios.
Withdrawals from 401(k) and traditional IRAs are classified as ordinary income, not capital gains. Why?
- Contributions were pre-tax: You have not paid income tax on the contributions, so taxes are deferred until withdrawal.
- Growth was deferred by taxes: The IRS allows investments to grow tax-free in these accounts, but recovers taxes later by treating withdrawals as income.
Once you think about 401(k) and IRA withdrawals Deferred incomeIt should now make sense why withdrawals are not taxed as capital gains. Heck, think of your entire 401(k) and IRA balance as a whole lot of tax-deferred income that the IRS is waiting to get their hands on if you want to.
All this time, you may have been assuming that your 401(k) and IRA investments would eventually be taxed as capital gains — at lower rates and not considered income. Unfortunately, you’d be wrong.
Because of these rules, large 401(k) or IRA balances can result in significant taxable income during retirement, especially when required minimum distributions (RMDs) are taken into account. Let us now go through an example of how a retiree can earn more in retirement.
Example of a retiree earning more in retirement
Here’s how combining RMDs, Social Security, and 401(k) can boost your retirement income:
Years of work:
- Annual salary: 120,000 dollars
- 401(k) contributions: $20,000 (average annual contribution before tax)
- Take home payment after subscriptions: 100,000 dollars
Retirement years:
- 401(k) Balance: $2 million (after 30 years of growth)
- Social security: $35,000 annually
- RMDs: At age 75, the IRS distribution factor is 22.9.
RMD = $2,000,000 ÷ 22.9 ≈ $87,336
- Total retirement income:
- RMD: $87,336
- Social Security: $35,000
- Total: $122,336
In this scenario, the retiree earns $2,336 more in retirement than he or she earns while working. But in terms of taxable income, depending on where a person retires, a retiree earns $22,336 more taxable income in retirement than at work. The $20,000 non-taxable annual 401(k) contribution while working for one year simply turns into taxable income in retirement.
Why retirement income also looks so much greater
Even if you make a little more in retirement than you do while working, it still seems much more for the following reasons:
- No need to save for retirement: The $20,000 you saved annually during your years of work is now available for spending. Not saving for retirement once you’re retired is one of the biggest savings “expenses” that working people don’t fully take into account. Treating investments as expenses is a smart mind trick to building more wealth over time.
- Low tax rate: Social Security is taxed at a lower rate, and effective tax rates for retirees are often reduced. For example:
- A single filer with income of $122,336 pays about $8,060 in federal taxes after the standard deduction.
- A married filer pays $0 in federal taxes due to the high 0% bracket thresholds and the standard deduction.
- Low expenses: Transportation, work clothing, and other work-related costs are eliminated in retirement.
- Earning side income just got more fun: For many retirees, part-time work becomes a satisfying way to stay active. The difference is that you are no longer acting out of necessity but out of choice. This shift brings greater satisfaction as you enjoy being productive, useful, and connected to your community.
- Earning investment income feels like free money: Earning passive investment income in retirement can almost feel like cheating, as it requires no sustained effort on your part. While it’s true that initially building your investments requires a great deal of work and discipline, over time, the power of compounding takes over.
It’s been a good semi-retirement so far
Even though I was earning about 80% less in total during my first year of retirement, I did not feel poorer. In my last two years, I was saving over 70% of my income in anticipation of leaving the workforce. So my actual disposable income only decreased by 10%.
Retirement has brought immense happiness as I have gained complete control over my time. I found it fun to explore the free parks on weekdays and have fun without spending a lot.
Writing to Financial samurai It was also much more fulfilling than working in banking. Without anyone dictating my assignments, I can freely explore my creativity and curiosity, and write about topics that truly interest me. Although the income level varies, the joy of writing makes it worthwhile. When you’re ready to write for free, any The income generated online feels like a bonus.
Maybe we’ll earn more in retirement after all
Not counting 401(k) and IRA withdrawals as income was a blind spot in my previous arguments for not wanting to contribute to a Roth IRA. View these withdrawals as Deferred income Explains why they are taxed as they are. For all 401(k) and IRA savers, the amount of deferred income the government eventually forces you to tap into is likely significant!
Another thing I didn’t fully appreciate was the power of multiplication. I understood it in theory, but it took another 15 years of experience for me to truly believe in its effect. Investment gains since April 2020 have been nothing short of exceptional.
Moreover, thanks to technology, more retirees are adopting side hustles to generate additional income. The very definition of retirement has evolved, from living a life of leisure to living a life of purpose.
If you want to contribute to a Roth IRA, do so — especially if your marginal income tax rate is 24% or less. Diversifying your retirement income sources is always a smart move.
The only thing better than earning more in retirement than you did while working? Retiring early and making more money doesn’t really work because you’re doing what you love!
Readers, do you think you will earn more in retirement than you will while working? Were you aware that withdrawals from 401(k)s and IRAs are taxed as ordinary income, or did you assume they would be taxed as capital gains because they are investments?
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