Many retirement plans assume the world stays the same, and it never has. Tax rates, inflation, and how long people live all change over time, but the planning tools people rely on often do not account for that.
These tools do a good job of testing how stock market ups and downs could affect your savings. But many of them assume today’s tax rates will last for the next forty years. Today’s rates are low compared with the past 50 years, so counting on them to stay that way is a risk in itself.
My research, published in the October issue of the Journal of Financial Planning, tests that assumption. I built a model that plays out 10,000 possible lives, from a person’s first job at 23 through retirement. Each life faces a chance of bad market years, rising prices, job loss or career breaks, a costly nursing care event, and tax rules that shift the way they have in real U.S. history. Two results stand out.
Saving up is harder than projected.
Standard tools estimate that a typical saver should have ended up with $1.7 to $2.8 million if they started 40 years ago. In my model, the median disciplined saver ended up with $302,000 (single) or $348,000 (married).
Putting off taxes can backfire.
I looked at retirees who spend their savings at a fairly high rate, about 6 to 7 percent a year with a 50/50 mix of stocks and bonds. Among married couples who saved only in traditional accounts, where taxes are paid when the money comes out, 31.1 percent still had money left at the end. Among couples who saved only in Roth accounts, where taxes are paid up front and withdrawals are tax-free, 63.2 percent did. A mix that follows a common rule of thumb among planners did about as badly as the traditional approach, at 31.8 percent. The difference is sometimes attributable to a big nursing care bill late in life. With traditional accounts, you may need to withdraw extra money just to pay the taxes on the money you spend, and if tax rates are higher by then, your savings drain faster. I call this “sequence of tax risk.”
This is a stress test. In the model, 60 percent of people need a two-year nursing facility stay late in life that costs $120,000 a year in today’s dollars and grows faster than inflation. My model leaves out state taxes, some other tax rules, required withdrawals at older ages, pensions, and the way some retirees cut back spending when money gets tight. Saving in traditional accounts is still the right choice for some people: those who need the tax break now to pay their bills, high earners who expect a few low-tax years just before Social Security begins, and people who plan to give to charity from those accounts. This model is no substitute for advice tailored to your own situation.
The lesson is to test your plan against changing tax rules, not only against stock market swings. A plan that only works if nothing ever changes isn’t much of a plan.
The research, methodologies, and views expressed are Carl Friedrich’s independent work, conducted using personal resources. They do not reflect the views, intellectual property, or endorsement of Farther Finance Advisors LLC. Simulation results are hypothetical, were not achieved by any actual portfolio or client, and do not guarantee future outcomes. They depend on the assumptions described above, including a 50/50 stock and bond mix and federal income tax only. They are not individualized investment or tax advice.
