There hasn’t been a formal proposal to eliminate income taxes yet, but if it does happen, there would likely be certain ramifications. For those preparing for retirement, no more income taxes could be largely beneficial for their investments and income. However, not all changes will be automatically positive.
Here’s how the elimination of income taxes could affect you and why you might want to change your retirement plans.
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No Income Tax Means Paying More Elsewhere
While federal income tax is nationwide, not every state has its own income tax. In fact, the following states don’t have it: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Washington and Wyoming.
For states that do have it, income tax is a major source of funds. State income tax can be used to fund major infrastructure projects, public schools and more. Those that don’t have it must rely on other sources of funding instead — like higher sales tax on goods and services.
If Trump eliminates income taxes, there’s a good chance that the cost of living will become higher in other ways. To illustrate this point, the Tax Foundation found that the average combined sales tax — local and state — ranges from 5% and 7%. In states with no income tax, the combined sales tax tends to be higher.
For example:
- Tennessee’s combined sales tax rate is 9.548%.
- Florida’s is 7.02%.
- Nevada’s is 8.23%.
- Texas’ is 8.20%.
- Washington’s is 8.86%.
If income tax is eliminated completely, or even drastically reduced, you may want to consider increasing how much you set aside for retirement. There’s a good chance costs are only going to continue to rise — possibly faster than they already do.
Sales tax isn’t the only thing to watch out for.
If income taxes are cut from the equation, property taxes could also potentially rise. So, unless you plan to rent during retirement, you may want to account for this when calculating your retirement budget and how much income you’ll need to live comfortably.
Social Security Benefits Could Still Be Taxed
Social Security is considered “unearned income,” but those who receive it may still have to pay income taxes on it. This largely depends on the individual’s assets and income bracket.
If your primary source of retirement income is Social Security, chances are you won’t have to pay taxes on your withdrawals. But if you anticipate having other income sources, up to 85% of your benefits could be taxable.
Eliminating federal income taxes could save you money there — and open up some greater cash flow in retirement. But unless Trump also gets rid of state income taxes, you’ll still need to prepare for those — depending on where you retire.
Potential Impact on Taxable Retirement Accounts
Once you retire and start drawing from your tax-deferred accounts — like 401(k)s, IRAs and certain annuities — you’ll have to pay taxes on those withdrawals. If you have these types of accounts, knowing how the elimination of income taxes could affect your retirement is essential.
Take the traditional IRA as an example. Your contributions are made with “pre-tax” dollars, meaning you can take them as a deduction for the year you contribute. This lowers your personal income taxes for the year. The trade-off is that you’ll need to pay taxes when you start drawing from that account in retirement.
If income taxes are eliminated, you won’t get the same initial benefit by contributing to a traditional IRA. On the other hand, you could also receive more in retirement, since you won’t have to worry about federal taxes — though state taxes could still apply.
“Without income tax, tax-advantaged retirement accounts like IRAs and 401(k)s might lose their appeal,” said Ryan Jacob, CEO, CIO and portfolio manager at Jacob Investment Management. Employers could also change their retirement benefits based on new tax laws, which could impact your retirement planning.
Other types of tax-advantaged accounts, like Roth IRAs, could also be impacted by Trump’s proposal. If it comes to pass, you may want to take some time to go over your various retirement income sources and make any necessary changes to bolster your retirement funds.
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