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Retirement Calculators With Taxes

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Does your retirement calculator make a reasonable estimate of your federal and state taxes in retirement?


Retirement Calculators and Taxes

For most Americans, taxes are significantly simpler in retirement than during our working careers. This doesn't mean, however, that you can ignore them altogether when planning for retirement. You will continue to pay state and federal taxes after you retire, and they will still be an important part of your financial life. However, many of the tax rules that will apply to you during retirement are very different from the tax rules that apply to your employment income. Therefore, you can neither ignore taxes after retirement nor simply estimate them based on your current taxes.


Social Security benefits

The good news is that only a fraction of your Social Security benefit will be subject to federal taxes. No more than 85% of your benefits can be taxed, and many people pay no federal tax on them at all. Where you stand in that spectrum will depend on the level of your benefits, your marital status, and the amount of any other taxable income.

In addition, chances are you won't pay any state taxes on your Social Security benefits. Most states do not tax Social Security benefits, including high-tax states like California and Hawaii. Of course, some states, like Texas and Florida, have no income tax to begin with. Starting with 2022, only the following states highlighted in gold may tax some of your Social Security benefit:

Even these states generally follow the federal rules, which means that only a fraction of your Social Security benefit will be taxed, if any. Some of these states add additional credits on top of the federal rules, which means that an even smaller portion of your benefit will be taxed.

Withdrawals from retirement accounts

When you retire, a large portion of your income will come from your savings. But you need to be careful, because the taxes you will pay on these withdrawals will depend on the type of account you are drawing from:

Pre-tax retirement accounts (such as 401(k), 403(b) or similar employer plans, traditional IRAs, SEP IRAs, or rollover IRAs) - Since you never paid taxes on this money, your entire withdrawal will be subject to regular income tax. In addition, if you withdraw money prior to age 59.5, you will also have to pay a 10% penalty on the amount withdrawn. To make things even more complicated, once you reach age 72, you will have to withdraw a minimum amount each year (called the "required minimum distribution"). This means that you may need to withdraw more than you need and get taxed on it.

Roth IRAs - Since your contributions to these accounts have already been taxed, you don't have to pay tax when you withdraw them. The big selling point of Roth IRAs is that you also don't have to pay tax on the interest you have earned! However, if you make a withdrawal prior to age 59.5, your earned interest may get taxed depending on the amount of the withdrawal.

Regular after-tax savings - These are your regular savings, outside of any special tax-advantaged retirement accounts. Since this money has already been taxed, there will be no further taxes when you make withdrawals. However, the portion of that withdrawal that is attributable to interest earned is taxable.

Capital gain from a home sale

Many Americans choose to sell their home in expensive urban areas after they retire and move to a less expensive area. Downsizing is a great way to fund your retirement, as it may generate a significant amount of cash. However, Uncle Sam (and your state) will want their share of the proceeds from the sale, too. There are two ways in which the tax on these proceeds may differ from regular employment income:

Lower tax rates: For federal tax purposes, it will be taxed at long-term capital gain tax rates (up to 20%), which may be significantly lower than regular income tax rates (up to 37%).

Large deductions: If the home was your primary residence, you can deduct $500,000 from the capital gain if married, or $250,000 if single. While this deduction is for federal tax purposes, it reduces your adjusted gross income, so you may effectively get the same deduction for state tax purposes as well.

Moving to another state

Many people consider moving to a state with a lower cost-of-living after retirement to make their savings stretch further. If you choose this strategy, it is crucial to consider the tax implications, too. In fact, some people move to a different state when they retire precisely to save on taxes. This decision would make it tricky to estimate your post-retirement taxes from your pre-retirement taxes. The different tax rules between states require a brand new tax projection based on the tax regulations in your new home state.

Mortgage interest

Your mortgage payments might be the same amount every month, but in the eyes of the federal and state tax authorities they are not. If you have a fixed-rate mortgage, the interest portion of your payment (and the corresponding tax deduction) will be smaller every month. When your mortgage is paid off, the tax deduction will disappear completely. So while your mortgage payments remain fixed, you tax payments may actually increase. It is important that your retirement plan takes this into account to avoid unexpected tax increases during retirement.

Is estimating your taxes in retirement even possible?

Obviously, it would be unrealistic and impractical to perform an exact tax calculation for each year in retirement. There's no way to know in advance every tax-relevant detail. Even if you did, would you really want to fill in a TurboTax-type questionnaire for each of your 30 years in retirement?

That said, with the right tools, a reasonable tax approximation at both state and federal levels is indeed achievable by making some conservative simplifying assumptions. This approximation can also be attained without an overwhelming number of technical questions.

Yes, life rarely goes exactly as planned and many people are skeptical about long-term projections. In our opinion, the right way to address uncertainty is by re-running your retirement calculator periodically, even after retiring, to reflect your actual financial situation. This way, you can make timely adjustments to your plan as unexpected changes happen. But uncertainty doesn't mean that we shouldn't use the best available data and models to develop the best possible projection of our future financial needs.

Taxes are no exception to this rule. To the extent possible and practical, a retirement calculator can and should make a reasonable estimate of your taxes in retirement. At a minimum, your retirement calculator should reflect the current tax brackets for federal and state purposes, increased with inflation. Then it can apply the basic tax rules for the items most common in retirement, as discussed above:

Social Security benefits

Withdrawals from retirement accounts

Capital gains from home sales

Mortgage interest

Employment income during retirement

That should cover most bases for most people. By necessity, your calculator would have to make some simplifying assumptions by ignoring some of the "bells and whistles" surrounding these rules. Some simplifications may be acceptable for retirement planning purposes, as very long financial projections—such as planning decades of retirement—are practically impossible to get 100% accurate.

But how do we decide what to ignore? Our proposed approach is to ignore tax rules only if they meet all three of these criteria:

Tax reduction: Does this rule always decrease taxes, if applicable?

Relatively small: Is the impact of ignoring this tax rule expected to be relatively small in most cases?

Onerous to user: Does this tax rule require additional inputs from the user?

The only tax rules mentioned in this article that meet these criteria are the special credits applied by states that tax Social Security benefits. These credits lower your taxes, they are unlikely to have a significant impact for most people, and they would potentially require a lot of additional questions for the user. For those reasons, ignoring them simply means that your retirement income may be slightly higher than projected by your retirement calculator. Other special credits and exemptions at state and federal level may also satisfy these criteria.

Tax rules NOT to ignore

If a tax rule fails one of the following criteria, it may be too risky or unnecessary to ignore it:

Tax increase: Ignoring a rule that may result in higher taxes (such as the 10% early withdrawal penalty), can put you at risk of running out of money in retirement. Even though you diligently re-ran the calculator periodically and followed its recommendations to the letter, your calculation will only be as good as your calculator. If a tax rule results in higher taxes for some people and lower taxes for others, it probably should be reflected by your calculation. A retirement calculator should not knowingly put even a small number of users at risk of unexpected tax increases.

Too conservative: We don't want to ignore any significant tax reductions (such as the fact that California doesn't tax Social Security benefits). By ignoring such major tax reductions, you may have to delay your retirement for too long until you have saved up much more money than you actually need.

While some conservatism is always warranted, large intentional departures from accuracy in the calculations is not the way to do that. Instead, you may consider using more conservative assumptions regarding your investment return, life expectancy, etc.

Note that the wording of the question includes "in most cases". It is impossible to guarantee that a rule will always be relatively small for everyone. This is why full disclosure of any simplifications is so important. This gives you, or your tax adviser, a chance to determine if any tax rules that have been ignored may be too conservative in your particular case.

No additional inputs required from user: If a tax rule doesn't require any additional inputs from the user and is just a matter of a programmer's time (such as the required minimum distribution), it should probably just get done, unless perhaps its complexity vastly outweighs its materiality.

Conclusions

Taxes are a tricky area for retirement calculators, especially considering that many are offered by financial institutions that simply wouldn't want the legal liability. This is probably why even advanced calculators used by financial advisers at top banks estimate your future taxes based on a guesstimate provided by you.

At the same time, your taxes will be very different in retirement and likely change significantly over time. Any reasonable approximation would be far more accurate than ignoring taxes or assuming some ballpark figure based on your current taxes. Such reasonable approximation is indeed achievable by using carefully selected criteria for deciding what tax rules can be safely ignored. The goal is to remain conservative enough to avoid unpleasant surprises while not getting overwhelmed with too many technical questions.

One possible implementation of the principles in this article can be found in our free retirement calculator, MoneyBee. It automatically projects all income sources for you and your spouse, and then figures the (approximate) federal and state tax you will owe in each year in retirement. Please note that neither our calculator, nor our firm, MyVal Center, provide any tax advice.