one of my biggest reasons was I am opposed to contributing to a Roth IRA because I believe most people will not make more money in retirement than they did while working. Therefore, they are less likely to pay higher tax rates in retirement than during their working years.
This belief also assumes that tax rates will remain stable. Since I first shared my thoughts on Financial Samurai in 2009, tax rates have generally trended downward. Just as cutting Social Security benefits is political self-inflicted harm, a campaign to raise taxes is not a winning strategy for politicians seeking power.
Earning more money in retirement than you did at work takes hard work, discipline, perseverance, and a little luck. Given the current state of personal finances in the U.S. — which isn’t great — this scenario is unlikely to happen for most people.
Intuitively, many people understand this. However, let’s dig into the numbers to get a clearer picture. I’ll also explore why some of us are likely to make more money 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 earn less when they retire
If we look at the median and average net worth of retirees, it’s logical to conclude that most Americans will earn more while working than in retirement.
- The median household income in the United States is approximately $80,000.
- Median personal income is approximately $43,000.
Now, consider a median net worth of $192,000 (based on the latest Consumer Finance Survey). Using the 4% rule (safe withdrawal rate), this net worth only generates $7,680 per year.
Fortunately, Social Security pays out an average of $22,333 per year, and increases every year with the index for inflation. Add these up, and the retiree’s total annual income is $30,013.
Compare this to the median personal income of $43,000. $30,013 is approximately a 30% reduction. The typical retiree’s median net worth would need to be at least $325,000 higher, or more than $517,000, to earn more in retirement.
On the bright side, a retiree making $30,013 a year doesn’t need to worry too much about taxes because there’s a standard deduction and lower marginal tax rates at that income level. I estimate that an individual could accumulate a portfolio of up to $1.5 million and still not pay much in taxes in retirement.
Whyyou You may earn more when you retire than when you work
Although most Americans earn less in retirement, you are not most people. Readers of personal finance sites like this are likely to save more than the average person and invest their money more strategically. We’re a bunch of nerds who care deeply about our financial future.
Decades of disciplined saving and investing could leave you with far more in retirement than you expected, thanks to the power of compound interest.
The power of compound interest
Let’s illustrate the incredible potential of compound interest. Let’s say you invest $100,000 and get an annual return of 10%. This example assumes no additional donations After an initial $100,000 investment. Here’s how your wealth grows over time:
- first year: $100,000 → $110,000
- Grade 10: $100,000→~$259,000
- Grade 20: $100,000 → ~$672,000
- 30 years old: US$100,000 → approximately US$1.74 million
- 40 years old: US$100,000 → approximately US$4.52 million
- 50 years old: US$100,000 → approximately US$11.74 million
It may take you 30 years to reach your first million, but by 50 years, compound interest will add millions to your portfolio every year. Starting early and investing consistently is the key to building significant wealth.
Why withdrawals are considered income
Another reason you can earn more in retirement is the tax treatment of withdrawals. I didn’t fully realize this until I spoke with Bill Bengen, the creator of the 4% Rule, and after I wrote another article about minimizing taxes when withdrawing from your retirement portfolio.
Withdrawals from 401(k)s and traditional IRAs are classified as ordinary income, not capital gains. Why?
- Donations are pre-tax: You pay no income tax on your contribution, so the tax is deferred until the withdrawal.
- Growth is tax deferred: The IRS allows investments in these accounts to grow tax-free, but then retaxes the withdrawals by treating them as income.
Once you consider 401(k) and IRA withdrawals as deferred revenueit should now be understandable why withdrawals are not taxed as capital gains. Heck, think of your entire 401(k) and IRA balances as a bunch of tax-deferred income, if you will, that the IRS is waiting to get their hands on.
All along, you may have thought that your investments in 401(k)s and IRAs would ultimately be taxed as capital gains—at a lower tax rate and not considered income. Unfortunately, you are wrong.
Because of these rules, a large 401(k) or IRA balance can generate significant taxable income during retirement, especially when required minimum distributions (RMDs) are taken into account. Now let us look at an example to understand how retirees can make more money after retirement.
Examples of retirees with higher income after retirement
Here’s how a combination of RMDs, Social Security, and a large 401(k) can lead to higher retirement income:
Working years:
- annual salary: $120,000
- 401(k) Contributions: $20,000 (average annual contribution before taxes)
- Take-home salary after contributions: $100,000
retirement years:
- 401(k) Balance: US$2 million (after 30 years of growth)
- social security: US$35,000 per year
- RMD: At age 75, the IRS distribution factor is 22.9.
RMD = $2,000,000 ÷ 22.9 ≈ $87,336
- total retirement income:
- RMD: $87,336
- Social Security: $35,000
- Total: $122,336
In this scenario, the retiree earns $2,336 more in retirement than he did while working. But in terms of taxable income, depending on where they retired, retirees made $22,336 more in taxable income in retirement than they did while working. The $20,000 in tax-free 401(k) contributions you make each year while working translates directly into taxable income in retirement.
Why retirement income feels higher too
Even if you earn a little more in retirement than you did when you worked, you’ll feel like you’re earning much more for the following reasons:
- No need to save for retirement: The $20,000 you saved each year while working can now be spent. Not saving for retirement after retirement is one of the biggest “expenses” working class people don’t fully consider saving. Treating investments like expenses is a smart technique for building more wealth over time.
- lower tax rate: Social Security tax rates are lower, and retirees typically have a lower effective tax rate. For example:
- A single filer earning $122,336 would pay about $8,060 in federal taxes after the standard deduction.
- Due to the higher 0% bracket threshold and the standard deduction, married filers pay only $0 in federal tax.
- Reduce expenses: Eliminate commuting, work clothing and other work-related expenses in retirement.
- Earning side income just got more enjoyable: For many retirees, part-time work becomes a fulfilling way to stay active. The difference is that you no longer work out of necessity, but out of choice. This transformation leads to greater satisfaction as you enjoy being productive, helpful, and connected to your community.
- Earn investment income that feels like free money: Earning passive investing income in retirement is almost like cheating—it requires no ongoing effort on your part. While building an investment initially requires a lot of work and discipline, over time the power of compound interest takes over and becomes the primary driver of returns.
It’s been a good semi-retirement so far
Even though my total income dropped by about 80% in my first year of retirement, I didn’t feel that much poorer. In the last two years of my working life, I saved more than 70% of my income in preparation for leaving the workplace. So my actual income available for spending has only dropped by about 10%.
The retirement transition brings me tremendous joy when I have complete control over my time. I find joy in exploring free parks on weekdays, keeping myself entertained without spending a lot of money.
write for Financial Samurai It’s also more fulfilling than working in a bank. Without anyone to assign me tasks, I am free to explore my creativity and curiosity and write about topics that truly interest me. Although income levels vary, the joy of writing makes it all worth it. When you’re willing to write for free, any The income generated online feels like a bonus.
Maybe we’ll make more when we retire
Not counting 401(k) and IRA withdrawals as income was a blind spot in my previous argument for not wanting to contribute to a Roth IRA. Treat these withdrawals as deferred revenue Clarified why they are taxed. For all you Super 401(k) and IRA savers out there, the amount of deferred income the government eventually forces you to tap into can be huge!
Another thing I underestimated was the power of compound interest. Conceptually, I understood it, but it took 15 years of experience to truly believe in its impact. Investment returns since April 2020 have been extraordinary.
Additionally, due to advances in technology, more and more retirees are turning to side hustles to generate extra income. The definition of retirement has evolved—from living a life of leisure to living a life of purpose.
What’s the only thing better than retiring with more money than you made while working? Retire early and make more money without really working because you’re doing something you love!
If you want to contribute money to a Roth IRA, go for it—especially if your marginal income tax rate is 24% or less. It’s always smart to diversify your sources of retirement income. This is about building up a chunk of tax-deferred and immediate taxable income for the day you no longer want to work!
Readers, do you think you will earn more in retirement than you did while working? Did you know that withdrawals from 401(k)s and IRAs are taxed as ordinary income, or do you think that since they are investments, they are taxed as capital gains?
Reach financial freedom faster with Boldin
If you’re serious about building wealth and retiring comfortably, consider signing up Boldin Powerful Retirement Planning Tools. They offer a free version and a PlannerPlus version for just $120 per year – an affordable alternative to hiring a financial advisor. For the paid version, there is a 14-day free trial.
Designed specifically for retirement planning, Boldin provides a comprehensive approach to financial management. It goes beyond managing your stock and bond portfolio by integrating real estate investments, guiding Roth conversions to minimize taxes, helping save for college, and solving other real-life financial scenarios we all face.
As I approach traditional retirement age, I’ve found Bouldin’s tools particularly helpful in deciding how much to convert to a Roth IRA. The ability to simulate various “what if” scenarios has been invaluable in planning for my future, especially as I get older and have less ability to manage finances.
Why You Can Make More Money in Retirement than When You Work is an original article from Financial Samurai. all rights reserved. Subscribe below and join more than 60,000 readers to accelerate your path to financial freedom Here’s the free Financial Samurai newsletter.
