Translate good times into a better retirement
When your income spikes, taxes, and other consequences may also rise, affecting your future plans in unexpected ways.
By Larry Jones, CPA
Having a great financial year in your career or business should make you feel good. A surge in income or profits are always welcome, and may seem like a reward for all you’ve put into your working life. That extra money can also supercharge your retirement savings.
Yet high earning years may come with downsides, too, affecting your short-term gains and your long-term prospects. Increased taxes, for example, can be a challenge. In a progressive tax system, additional wage income may be taxed at a higher rate, and combined federal, state, and local levies could siphon off more. With our top marginal rate at 37%, Medicare and investment taxes, plus state taxes, the top rate could be closer to 44% or 45%‡. For business owners, rates on added profits might be lower, but could still reduce the value of the extra income.
Every year won’t be great
There’s also a risk of overconfidence. Those who assume that future years will be just as bright as the last one may be ignoring the reality that economic growth is inevitably cyclical, masking their own need for multi-year planning. Between 1945 and 2019, the end of the most recent business cycle, the average expansion has lasted about 65 months, and the average recession has lasted about 11 months§. In today’s volatile economic environment, one can hope for the best but should prepare for the worst, or at least a slowdown.
“This is one of those situations likely to be truly unique for each person. So regardless of the source of an income spike, I suggest that clients quickly contact their advisor to discuss potential tax ramifications and best-use of the funds.”
Wealth Strategist, Huntington Private Bank®
When a downturn finally comes, business and job losses, combined with a stock market retreat, could be devastating to the retirement outlook of those who haven’t prepared. If the market is dropping during the early years of retirement, for example, withdrawals could drain savings quickly, leaving much less than expected for later years.
Suppose a couple retired with $2 million in assets. If they withdrew 4% in the first year—one rule of thumb for a percentage that can be safely distributed from a portfolio annually—and investment losses subtracted an additional 20%, only $1.52 million would remain. Additional losses and withdrawals during the early years of retirement could further diminish that amount.
Tax deductions for high income earners
Much of the conventional wisdom surrounding tax planning as it relates to retirement is based on the notion that your income, and your taxes, will be lower when you’re no longer working.
For high income earners, that can make it beneficial to defer current income until retirement. In particularly high earning years, receiving the income now and paying taxes on it all at once could result in higher payments than if the money were deferred and taxed over several years at lower rates during retirement.
A $1 million bonus, for example, for someone paying a top combined tax rate of 42%, could result in a $420,000 tax bill. If it were spread out in retirement and taxed at, say, a combined rate of only 29%, total taxes could be $130,000 lower.
For example, when working with a client whose bonus one year more than doubled her compensation, it was important for her to look at all of the possible ways to reduce current income to avoid having a lot of it taxed at the highest rates. In such situations, the best advice may sometimes be to defer, defer, defer.
Is this the right time to build your business?
Owners may not know what to do with excess cash in a business but do have an incentive to reduce taxable income when they have a great year. But their strategies may involve putting money back into the company.
This can be a time to optimize your business, particularly if you’re looking ahead to retirement and planning to sell the company. It all depends on the facts of your situation. It could be a good time to invest in equipment or property, or pay down debt.
There may also be an opportunity to do things to attract or keep key employees. For one business, that meant establishing a retirement plan for employees that enabled the company to match a part of their contributions. The key is to determine what your goals are for yourself and your business. We can help you find planning opportunities, in good years and not-so-good years, that fit your facts. To learn more, please contact your Huntington Private Bank team to see how we can help or find a Huntington Private Bank office near you.
‡ Alex Durante. “2023 Tax Brackets.” Tax Foundation. Accessed July 24, 2023.
§ Congressional Research Service. Jan. 3, 2023. “Introduction to U.S. Economy: The Business Cycle and Growth.” Accessed July 24, 2023.
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