Why Retirees Can’t Absorb a Tax Hike

With the election upon us and the fiscal cliff looming, tax rates are on a lot of minds--especially retirees and those saving for retirement. A new survey shows how higher rates would curb retirement saving.

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With Election Day here and the fiscal cliff looming, it’s at least topical to consider the impact of higher tax rates on retirement saving. The short answer: Higher tax rates would hurt.

We already have a massive retirement savings shortfall in America. Our pension system is sinking and boomers on average are projected to have just 44% of the income they will need in retirement to maintain their lifestyles. The weak economy has taken a toll on our ability to save. From a retirement perspective, the last thing we need is higher tax rates.

Yet higher rates are almost certainly coming. The George W. Bush tax cuts of 2001-2003 are set to expire at the end of this year—a large part of the so-called fiscal cliff, which would also restore payroll taxes to higher levels and end other tax breaks. President Obama has signaled a willingness to let some of this come to pass. Mitt Romney would like to extend the Bush tax cuts for everyone.

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More than half of boomers say that if their federal income tax burden rises they will be less likely to save, according to a recent survey by the Insured Retirement Institute and Welfel Research. The top marginal income tax rate for individuals is set to jump to 39.6% from 35% if the Bush tax cuts expire.

And 39% of respondents say that higher capital gains taxes would deter them from saving. For most people, the current rate on capital gains is 15% and would rise to 20%. Nearly as many (36%) said they would be less likely to save if the Social Security tax on individuals is restored at 6.2% from the current 4.2% rate, according to the survey.

It matters little that tax-advantaged savings ceilings will be raised next year—to $17,500 from $17,000 in 401(k) plans and to $5,500 from $5,000 for IRAs. Many people simply don’t have the resources to take advantage of those higher limits. In the survey, 56% said the new IRA limits would have no impact on their saving and 46% said the same thing about the new 401(k) limits.

If President Obama gets his way taxes will rise only for the wealthy, defined as singles earning more than $200,000 a year and couples earning more than $250,000. According to the Brookings Institute and Urban Institute, that would mean only 4% of taxpayers would feel the sting. But others believe that eventually rates must rise for a broader section of the population.

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Tax rates are a big deal for retirees and pre-retirees. Most financial planners use tax mitigation strategies as a centerpiece of their clients’ retirement planning, figuring that modest tax savings translates into significantly more retirement income over three decades. Taxes may be a retirees’ single biggest expense, claiming 31% of the budget of retirees with $100,000 of income, according a study by Lincoln Financial. That study also found that the relatively high tax toll was among retirees’ biggest surprises.

Retirement savings, of course, is only one small consideration in shaping the nation’s budget and tax policy. It’s also useful to note that what really keeps people from retiring in style is too little saving discipline, too much debt, and too little control over their spending. Take care of those things and the specter of higher taxes wouldn’t seem so ominous.