The Bogleheads' Guide to Retirement Planning (7 page)

The effect of a market downturn can be seen in the Employee Benefit Research Institute (EBRI) Survey in
Table 1.1
. In the 2008 data, note the 15 percent drop in retirees’ confidence that they would have enough money to live comfortably in their retirement years. This survey was conducted in January 2008, nine months prior to the financial crisis in October 2008.

Housing downturns also put your plan at risk. As evidenced by the 2008 housing downturn and credit crisis, even the family home can be at risk. Traditional thinking on housing was to buy the biggest house you can afford because it will always go up in value. That may no longer be accurate. The foresight not to put more money into housing than is needed to meet your needs may help you stay on track for retirement.

Changes in the law or the tax code are also unpredictable events that could affect disposable income needed in retirement. Changes that have been proposed in the past, such as increasing income taxes or capital gains taxes or reducing the cost of living adjustment for Social Security benefits would also have an impact on a retiree’s standard of living. People approaching retirement and those already retired should be flexible in their planning
and living
to adjust to changes as they occur. Tax law changes may mean a few years of no inflationary increase in annual withdrawals from retirement funds and/or reductions in some discretionary expenses.

Health-care costs in retirement represent both the greatest known additional expense for retirees and the greatest potentially unknown cost. Be mindful that cost of coverage is likely to continue to increase in the years ahead and that the benefits from government programs are apt to decrease. It is prudent for retirees to overestimate health-care costs and underestimate benefits from government health insurance programs.

Although computer models can provide a withdrawal strategy based on inputs, they cannot anticipate scenarios where future investment returns and rates of inflation are vastly different from those of the past or tell you what the cost of health care will be when you really need it. The only way to protect against these unknowns is to rework your plan annually to reflect the new realities.

Saving for retirement should start at an early age, as soon as a person has steady income from employment. Planning for retirement is done later in life, once a person has lived a good many years and is comfortable with present living standards. Everyone over the age of 50 should have a written plan that lays out goals for retirement living and the financing that will support them. Younger planners, too, should have a written plan. Their plan should focus more on examining their personal and financial values, committing to a plan with their partner, establishing some long-range financial goals, and indicating the strategies they will use to achieve them.

If you are within a decade of retirement, your planning should add detail about what you expect to do during your postretirement years. Your annual financial plan adjustments should reflect changes in your life and explore additional strategies for achieving your financial goals if it appears you will fall short. Creating a clear vision of your future life provides the positive affirmation you need to choose the most meaningful course of action today, without a feeling of regret or denial. Above all, stay on track as best you can through good and bad economic times. Focus on what brings happiness to your life, and consider your financial resources as a means to that end.

Benjamin Franklin is credited with the saying “Nothing is certain except death and taxes.” Uncle Sam is our partner in everything we do, and that means paying him part of our income. Why are we taxed? The grander purpose of paying income tax was articulated by IRS Tax Commissioner Mark W. Everson in IRS Publication 17: “Paying taxes is a unifying experience fundamental to democracy and the rule of law. Each year, almost two hundred million taxpayers carry out this vital obligation by filing their return.” In the United States and in all great democracies, people are resigned to paying income taxes. In performing their duty to their country, citizens complete their tax forms and send in checks when necessary. However, we also have an obligation to ourselves not to overpay; rather, we should strive to pay only the minimum amount of tax legally attributed to us.

Understanding how different types of income and capital gains are taxed is the starting point for managing your tax obligation. This chapter helps you understand the key aspects of income tax as they pertain to retirement planning. Minimizing the impact of taxes while in retirement is critical because it maximizes your discretionary income from pensions, Social Security, and your portfolio.

Our tax law is long, complex, and intimidating. Nevertheless, you should make an effort to understand how taxes work because that will save you money. This chapter focuses on understanding the relevant parts of the federal and state income tax laws pertaining to your savings. By knowing the law, you can avoid the unpleasant surprise of an unexpectedly high tax bill. The good news is that most people planning for retirement need to be concerned with only a small subset of the tax law.

Some people say they do not need to know any tax information. They say, “Well, that is why I hire a tax professional.” Hiring a professional tax preparer is fine, but like most aspects of life, it is best to have some knowledge of the information yourself so that you can either prepare your taxes yourself or engage in a useful dialogue with your tax professional. The more you know about taxes, the better off you will be.

One of the best places to gain tax knowledge is directly from the tax collectors. The Internal Revenue Service (IRS) has a library of tax documents at our disposal. It is easy to access IRS forms and publications online at
www.irs.gov
. At a minimum, you should obtain a copy of
Your Federal Income Tax for Individuals,
Publication 17. It is your first reference for tax questions. States that collect state income tax offer similar publications.

Invest the time necessary to understand the tax code that relates toyour specific situation. From that solid foundation, paying attention to tax-changes that take place from time to time is relatively painless and will keep you up-to-date and informed concerning your own taxes. One caveat: the tax code is the product of a political process and typically has many exceptions for each rule. It is therefore important to investigate each case where you do not exactly fit the standard rule. References at the end of this chapter will provide the tools you need to fully explore your specific situation.

Most income tax paid by individuals is paid to the federal government. A fundamental aspect of our federal income tax system is that it is progressive; that is, the tax rate increases as the taxable amount increases. In other words, people with higher taxable incomes pay a higher tax rate on their income than people who earn less.
Table 2.1
illustrates the 2009 tax brackets for married taxpayers filing jointly and for single filers.

The IRS tax tables show marginal tax rates, the rate at which your next dollar of income would be taxed. For example, assume married taxpayers file a joint return showing taxable income of $68,000. Any money earned between $67,800 and $137,050 is taxed at 25 percent, the marginal tax rate.

How your next dollar of income is taxed may have an impact on how you invest. It is an important concept because how that next dollar is treated may affect your decision to invest in taxable bonds, tax-free bonds, or another investment. Understanding your marginal tax rate will make these investment decisions easier.

With the concepts of a graduated income tax and your marginal tax rate in hand, next it is important to understand that different types of income maybe taxed at different rates. The rest of this section on federal income taxes will explore in detail the different types of income and how they are taxed. If you have a copy of your latest Form 1040 tax return handy, pull it out, and you can follow along as the various types of income are discussed.

On the 1040, the first type of income listed is “wages, salaries, tips, etc.” As Form 1040 says, “Attach Form(s) W-2.” This form is supplied by your employer to you (and to the IRS). All income reported on a W-2 is taxed as ordinary income, as shown in
Table 2.1
. If you received a raise during the year, those additional dollars are taxed at your marginal tax rate.

Other income that is taxed as ordinary income includes taxable interest, ordinary dividends, taxable refunds, alimony received, business income (or loss), IRA distributions, pensions and annuities, rental real estate, royalties, partnerships, trusts, and unemployment compensation.

Source:
U.S. Internal Revenue Service

Interest from bank accounts, taxable money market mutual funds, and certificates of deposit (CDs) are taxed at ordinary income tax rates. Investors receive a Form 1099-INT at the end of the tax year from the issuer documenting the amount of interest earned from that specific investment. Stock and bond mutual funds refer to income as dividends, but some of that income is actually interest income. That is why you should refer to Form 1099-INT and other tax documents provided by mutual funds and brokerage firms when completing your tax returns.

Interest from most municipal bonds and municipal bond money market funds is tax-exempt, meaning that the interest is free from federal income tax. The exceptions are private purpose bonds used to finance such projects as a sports stadium. If you own tax-exempt bonds via a mutual fund, the fund company will break out the interest that is tax-exempt and the interest that is subject to federal income taxes, if any.

Dividends are payments by corporations on their outstanding stock. They are also the portion of payment from mutual funds that is reported to the IRS as a dividend rather than as interest. The present tax code applies lower tax rates for certain corporate dividends and mutual fund dividends. They are called qualified corporate dividends. The tax rate on qualified dividends is between 5 percent and 15 percent, depending on yourmarginal tax rate.