One of the biggest reasons I’ve been against contributing to a Roth IRA is my belief that most people won’t make more money in retirement than they did while working. As a result, they are less likely to pay a higher tax rate in retirement than in their working years.
This theory also assumes that tax rates will remain stable. Since 2009, when I first shared my views on Financial Samurai, tax rates have generally dropped significantly. Just as cutting Social Security benefits is politically self-defeating, campaigning to raise taxes is not a winning strategy for politicians seeking power.
Earning more in retirement than during your working years takes effort, discipline, consistency, and some luck. Considering the current state of personal finances in America—which is not good—this scenario is unlikely for most people.
Intuitively, most people understand this. However, let’s get into the math to get a clearer picture. I will also explore why some of us may end up earning more in retirement than we did while working. The key is to understand the concept of deferred income and how it is taxed.
Why Most People Will Earn Less in Retirement
Let’s check the numbers. Looking at the average and median number of retirees, it is reasonable to conclude that most Americans will earn more while working than when they retire.
- The median household income in the US is around $80,000.
- The median per capita income is approximately $43,000.
Now, consider the average income of $192,000 (based on a recent study by Consumer Finance). Using the 4% rule, a safe withdrawal rate, this amount only produces $7,680 per year.
Fortunately, Social Security provides an average payment of $22,333 per year, and it increases by an index of inflation each year. Adding these together gives retirees an annual income of $30,013.
Compare this to the median per capita income of $43,000. Not only is $30,013 very low, but it’s also about 30% less. The median net worth would need to be at least $325,000 more, or more than $517,000, for the average retiree to make more in retirement.
On the bright side, retirees earning $30,013 a year don’t have to worry too much about taxes because of the standard deduction and low minimum tax rate at this income level. I estimate that people can accumulate a portfolio of up to $1.5 million and not have to pay much if any taxes in retirement.
WhyYou You May Earn More in Retirement Than Working
While most Americans have low incomes in retirement, most people don’t. Readers of personal finance sites like this one probably save more and invest more wisely than the average person. We are a no-nonsense group that cares deeply about our financial future.
Thanks to the power of compounding, decades of disciplined saving and investing can result in more retirement income than you expected.
The Power of Integration
Let’s illustrate the amazing power of compounding. Let’s say you invest $100,000 and get a 10% annual return. For example we take 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, compounding adds millions a year to your portfolio. Starting early and staying invested is the key to building significant wealth.
Why Withdrawals Are Considered Income
Another reason why you should have more money in retirement is the tax treatment of your withdrawals. This point didn’t fully hit me until I spoke with Bill Bengen, the creator of the 4% Rule, and wrote another post about reducing taxes when withdrawing from retirement portfolios.
Withdrawals from 401(k)s and traditional IRAs are classified as ordinary income, not capital gain. Why?
- Donations were pre-tax: You didn’t pay income tax on the donations, so taxes are deferred until withdrawn.
- Growth is tax-deferred: The IRS allows investments to grow tax-free in these accounts, but it also withholds taxes over time by treating withdrawals as income.
If you think of 401(k) and IRA withdrawals as deferred incomenow it should make sense why withdrawals are not taxed as capital gains. Heck, think of all your 401(k) and IRA balances as a giant pot of tax-deferred income the IRS is just waiting to get its hands on if you will.
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 included. Now let’s take an example of how a retired person can make more money in retirement.
Example of a Retiree Earning More in Retirement
Here’s how a combination of RMDs, Social Security, and large 401(k)s can lead to higher retirement income:
Working Years:
- Annual Salary: $120,000
- 401(k) Contributions: $20,000 (pre-tax annual average contribution)
- Pay Home After Contributions: $100,000
Retirement Age:
- 401(k) Balance: $2 million (after 30 years of growth)
- social Security: $35,000 per year
- RMDs: At age 75, the IRS distribution factor is 22.9.
RMD = $2,000,000 ÷ 22.9 ≈ $87,336
- Net Retirement Income:
- RMD: $87,336
- Social Security: $35,000
- Total: $122,336
In this scenario, the retiree earns $2,336 more in retirement than while working.
Why Retirement Money Can Feel Too Big
Making $2,336 more per year in retirement (+2%) than while working is not a significant amount. However, it sounds too big for the following reasons:
- No Need to Save for Retirement: $20,000 saved annually during the working years is now available for use. Not saving for retirement is one of the biggest savings “expenses” that working people are not fully responsible for.
- Low Tax Rate: Social Security is taxed at a lower rate, and effective tax rates are generally reduced for retirees. For example:
- A single filer with an income of $122,336 pays ~$8,060 in federal taxes after standard deductions.
- A married filer pays $0 in federal taxes because of the 0% upper bracket limits and the standard deduction.
- Reduced Costs: Going to work, work clothes, and other work-related expenses are eliminated.
- Earning Money Gets More Fun: For many retirees, part-time work is a satisfying way to stay busy. The difference is that you no longer work out of necessity but you no longer work out of choice. This change brings great satisfaction as you enjoy productivity, service, and communication with your community.
It’s been a good Half Retirement so far
Despite earning about 80% of my gross income in my first year of retirement, I didn’t feel poor. In my last two years of work, I have been saving more than 70% of my salary in anticipation of leaving the workforce. The change brought great joy as I was in full control of my time. I found joy in exploring free parks during the week, keeping myself entertained without spending a lot of money.
Writing to you A financial samurai and it has been more fulfilling than working in a bank. Without anyone calling me my works, I can freely explore my creativity and curiosity, writing about topics that really interest me. Although the income is different, the joy of writing makes it worthwhile. If you are willing to write for free, any income from the Internet sounds 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 earlier arguments. Viewing this withdrawal as deferred income explains why they are taxed as such. For all the super 401(k)s and IRAs you save, the pot of deferred income the government eventually forces you to tap into will likely be huge!
In addition, thanks to technology, many retirees are embracing the hustle and bustle for extra income. The very definition of retirement has changed—from living a life of leisure to living a life of purpose.
The only thing better than earning more in retirement than when you were working? Retire early and make extra money while still working!
Students, do you think you will earn more when you retire than when you were working? Did you know that withdrawals from 401(k)s and IRAs are taxed as ordinary income, or did you think they would be taxed as capital gains since they are investments?
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Why You Can Make More in Retirement Than Working first post by Financial Samurai. All rights reserved. Join 60,000+ students who are accelerating their path to financial freedom by signing up Free Financial Samurai newsletter here.
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