A basic retirement plan includes estimating your retirement expenses and figuring out how you will cover those costs. Once you have done that rough estimate, you will need to refine your retirement projections and begin to account for inflation and taxes. Remember to include these often missing details in your retirement plans:
Save more as your salary increases. Don't just save a constant amount each year until retirement. As you get raises over time, put more money aside for retirement. If you work hard your raises may beat inflation many times over, because you'll get promotions and better opportunities.
Retirement account contribution limits will increase. The amount of money you can defer paying tax on generally increases each year because many tax-advantaged accounts have inflation adjustments built in. In other words, you'll be able to defer tax on even more income as your career progresses. The increases are likely to be small every year, but they will add up to a sizable amount over the course of your career.
Tax brackets will change. One of these days it could take a million dollars in earnings just to be in the 25 percent tax bracket. It sounds crazy, but inflation adds up over time. Inflation won't just increase your expenses, but the tax brackets as well. If you take out the same amount year after year in retirement, you might get to keep more for yourself later on in retirement.
Figure out which income sources are adjusted for inflation. Some pensions and annuities are not adjusted for inflation, but Social Security payments and some types of bonds do grow to keep up with inflation. Figure out which income sources are adjusted for inflation and make sure that you will still be able to cover your bills after several decades of inflation.
Various investments will be taxed at different rates. Many people calculate their tax liability based on an estimated withdrawal amount. Yet, your real tax liability in retirement will be based on a variety of income sources including how much you take from each account, whether there are any capital gains taxes to be paid, whether you have dividend and interest income and how much you get from Social Security. You need to look at all of your income sources to get an accurate picture of how much tax you will pay in retirement.
Discount money in pre-tax accounts. Many people forget to account for Uncle Sam's share of their pre-tax retirement accounts including 401(k)s and IRAs. The good news is that most retirees don't pay a lot of taxes in retirement, so the effect is small for most people. But the tax bite becomes bigger the more you save. So, remember to subtract out the income tax you will pay on retirement account withdrawals when projecting your retirement income.
Saving and investing are often thought of as the most important components of a retirement plan. But a solid retirement plan also needs to include estimates for taxes and inflation.
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