If You're in the 2% Club, the 'Tax-Free Retirement' Myth Doesn't Apply to You
Eighty percent of retirees pay $0 in federal income taxes, but since you have a pension, you're likely in the 20% who will pay taxes. Here's why and what to do about it.
If you have a pension and substantial retirement savings, your tax situation could look very different from that of the average retiree.
You might have heard the statistic: Roughly 80% of retirees pay no federal income taxes. If you have a pension and a million dollars or more saved for retirement, you might read that statistic and think, "There's no way that applies to me."
You're probably right.
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As a CERTIFIED FINANCIAL PLANNER® and the founder and CEO of Peak Retirement Planning, we work primarily with what we call the 2% Club — people who have pensions and $1 million or more saved (I wrote a book about this group — you can request it for free here).
We see a pattern that runs counter to the retirement advice many of us have heard throughout our working years. We were told that we would be in a lower tax bracket once we stopped working, but for retirees with substantial pensions and significant tax-deferred savings, that outcome isn't guaranteed.
In fact, you might find yourself in the same or an even higher tax bracket.
The good news is that having to pay taxes in retirement is hardly a bad problem to have. It means you have income and assets that many retirees don't.
However, I don't believe you should pay a penny more than necessary, and the key is understanding why most retirees can avoid federal income taxes and why your situation may require a different strategy.
You can watch my video on this topic:
Why so many retirees pay no federal income tax
The primary reason is the standard deduction. The standard deduction allows taxpayers to exclude a certain amount of income from federal taxation. For retirees with relatively modest income, that deduction can eliminate much or all of their taxable income.
Consider a hypothetical retiree with $500,000 in an IRA, no pension and Social Security as their primary source of income. At age 73, that person would begin taking required minimum distributions (RMDs). A roughly 4% withdrawal from a $500,000 account would generate about $20,000 of taxable income.
That isn't a particularly large amount of income when compared with the standard deduction, especially when additional deductions available to older taxpayers are considered.
Social Security also isn't necessarily fully taxable, as the amount of Social Security benefits included in taxable income depends on a retiree's overall income, and in this case, little or none of their benefits will be taxable.
That's how you can arrive at a retiree with retirement income who still owes little or even $0 in federal income taxes.
Now let's change the equation.
A pension can change everything
A pension is one of the greatest retirement benefits you can have. It provides something that millions of Americans don't have, which is a predictable income for life.
But from a tax-planning perspective, that guaranteed income often creates a challenge. Instead of starting retirement with relatively little taxable income, a pension holder frequently has three significant sources of retirement income:
- A pension
- Social Security
- Withdrawals from tax-deferred accounts such as 401(k)s, IRAs, TSPs or 403(b)s
I call this the three-legged stool of retirement income. It can provide tremendous financial security, but it can also create a substantial tax bill.
If your pension alone provides $50,000, $100,000 or even several hundred thousand dollars annually, you have already moved well beyond the situation facing the retiree with $500,000 saved and no pension.
Then add Social Security and eventually RMDs, and your taxable income can climb even higher. That's why I tell pension holders to stop comparing their tax situation with the average retiree. Your retirement income strategy needs to be built around your specific numbers.
Your Social Security could become taxable, too
Social Security taxation is another reason pension holders can find themselves paying more than expected. Depending on your income, up to 85% of your Social Security benefits can be included in taxable income.
For many of the clients we work with, that full 85% is taxable because their pension and other income push them above the relevant thresholds.
This can create a compounding effect. Your pension generates taxable income, which can cause more of your Social Security to become taxable, which then increases your overall taxable income.
And that's before we even get to your retirement accounts.
RMDs can become a bigger problem over time
One of the biggest mistakes I see is treating RMDs as if they're a problem for someone else. They're not. If you have substantial tax-deferred savings, you need to think about what those accounts could look like when RMDs begin.
Let's say you're 60 years old with $1 million in tax-deferred retirement accounts. If those assets grow significantly over the next decade or more, you could reach your RMD years with substantially more than $1 million.
This creates a very different tax problem. The percentage you are required to withdraw increases as you age, and you have to take those distributions regardless of whether you actually need the money for spending.
This could leave you in a situation where your pension and Social Security already provide enough income to live comfortably, yet the government requires you to withdraw additional money from your IRA. This additional income can push you into higher tax brackets and affect other parts of your retirement plan.
Medicare adds another layer
Your income doesn't just determine your federal income tax bill; it can also affect your Medicare premiums through the income-related monthly adjustment amount, or IRMAA.
If your income increases enough, you will find yourself paying more in premiums for Medicare Part B and D for the exact same coverage as someone with a lower income.
This is one reason I don't think retirement tax planning should focus solely on the federal tax bracket you're in. The real question is: What is your all-in cost?
This includes federal income taxes, Social Security taxation, Medicare premiums, capital gains and, depending on where you live, state income taxes.
Tax diversification can give you more control
Most diligent savers we work with did exactly what they were told to do throughout their careers: They put money into their 401(k), IRA, TSP or other tax-deferred accounts, received the tax deduction and kept saving.
That's a great way to build wealth, but there's a potential downside when you reach retirement: You could have too much of your wealth sitting in one tax bucket.
If nearly all of your retirement savings are tax-deferred, you don't have complete control over your future tax bill, and when you need additional income, you typically have one option: To recognize more taxable income.
That's why I like the concept of tax diversification. Instead of having all your money in tax-deferred accounts, consider building a combination of:
- Tax-deferred accounts. Traditional IRAs, 401(k)s, TSPs and similar accounts
- Tax-free accounts. Roth IRAs and Roth 401(k)s
- Taxable accounts. Brokerage and other investment accounts
The goal isn't necessarily to maximize one category but to create flexibility. If tax rates are high, having money in a Roth account could give you a source of retirement income without creating additional taxable income, and if tax rates are lower, you could draw from tax-deferred accounts instead.
You can't predict exactly what tax laws will look like 10, 20 or 30 years from now, but you can build a portfolio that gives you choices.
Roth conversions could be especially valuable for pension holders
This is where Roth conversions enter the conversation. A Roth conversion allows you to move money from a tax-deferred account into a Roth IRA, paying the applicable taxes on the converted amount today. Once the money is in the Roth, qualified withdrawals are tax-free, and Roth IRAs don't have RMDs during the original owner's lifetime.
For a pension holder with substantial tax-deferred savings, this can be a powerful planning tool, but I don't recommend converting money simply because someone says, "Roth is tax-free."
The question is more nuanced: What tax rate are you paying today compared with the tax rate you could face later?
If you have a large pension, substantial retirement savings and years before RMDs begin, you could have an opportunity to gradually move money into the Roth while managing your tax bracket.
For example, someone with a $100,000 pension has a very different future tax picture from someone with no pension. Add $1 million or more in tax-deferred accounts, and future RMDs could become significant.
A Roth conversion could reduce the size of those future RMDs while also creating a pool of money that grows without future RMDs for you.
But there's an important caveat: Don't convert blindly. Converting too much may push you into a higher tax bracket, increase your Medicare premiums or create other unintended consequences.
Converting too little might leave valuable lower tax brackets unused. The objective is to find the right amount, not simply the biggest amount.
Don't forget about the widow's penalty
There's another tax issue that married couples need to consider long before it happens: The so-called widow's penalty. While you're married, you generally file a joint return and benefit from married-filing-jointly tax brackets and deductions. When one spouse dies, the surviving spouse eventually files as a single taxpayer.
At the same time, the surviving spouse could lose one Social Security benefit while continuing to have pension income and retirement assets. In other words, income declines while the tax brackets become less favorable.
That's why I encourage couples to plan for both spouses, not just the tax situation they have today.
One strategy could be taking larger withdrawals or completing Roth conversions during the years when both spouses are filing jointly. Doing so could reduce the amount of tax-deferred money that remains for the surviving spouse. It's essentially risk management for your tax plan.
Your retirement goal matters, too
Tax planning isn't only about minimizing taxes; it's about aligning your tax strategy with what you actually want to do with your money.
If your goal is to spend your savings during retirement, it could make sense to take advantage of the earlier years of retirement, when you're healthy enough to travel, pursue hobbies and enjoy the wealth you've accumulated. I call these the "go-go years."
If your goal is to leave a significant legacy, the strategy could look different. A Roth conversion could turn tax-deferred assets into a potentially tax-free legacy for your heirs while also eliminating lifetime RMDs on the converted Roth assets.
Either way, your retirement tax strategy should start with your goals, not simply a desire to pay the lowest possible tax bill this year.
You might not be able to join the 80%, but you can still pay less
If you have a pension and substantial savings, you probably aren't going to replicate the tax situation of a retiree with modest income and no pension. And that's OK. I'd rather have a large pension and substantial retirement savings and pay some taxes than have no taxable income because I didn't save enough.
But there's a big difference between paying taxes because you have significant income and paying more taxes than necessary because you didn't plan ahead. If you're a pension holder with significant retirement savings, start by asking yourself some questions:
- How much taxable income will my pension create?
- How much of my Social Security will be taxable?
- What will my RMDs look like at 73, 75 and beyond?
- Could my RMDs push me into a higher tax bracket?
- Could my income increase my Medicare premiums?
- How much of my retirement savings is tax-deferred vs tax-free?
- Would Roth conversions make sense while I'm still working or early in retirement?
- What happens to my spouse's tax situation if I die first?
- What happens to my heirs if I leave them a large tax-deferred account?
- Where will I live in retirement, and how will state taxes affect the equation?
You might not be able to eliminate your retirement tax bill. But with the right planning, you can potentially reduce it, spread it out and gain more control over where and when you pay it.
That's the goal we have for our clients: Pay your fair share, but not a penny more.
Related Content
- 8 Retirement Tax Strategies Your CPA Won't Tell You
- When Is a Roth Conversion a Bad Idea? 6 Situations Retirees Should Consider Carefully
- Why a Roth Conversion Is Wrong for Most People But Often Right for Pension Holders
- 13 Things to Know About How Your Pension Affects Your Taxes in Retirement
- Many Retirees With a Pension and $1 Million-Plus Do These 7 Things (and Regret It Later)
