Understanding Legislative Risk in Retirement Planning

Retirement can be full of risks—an unpredictable stock market, fluctuating interest rates, and the potential of outliving your income. However, there are other significant risks that many Americans haven’t fully addressed, even in the most comprehensive retirement strategies. Among these often-overlooked risks are tax and legislative risks, which have the potential to significantly reduce the amount of income you can spend in retirement.

The Overlooked Risks

Many retirees focus on how they want to grow, protect, and spend their funds in retirement but often neglect to consider how taxes might impact their retirement funds. Unexpected changes in the level or structure of taxation could reduce your spendable income in retirement.

Tax Risk

Tax risk concerns the possibility that your taxes will be higher in retirement than anticipated. This means a larger portion of your income could end up going to the IRS, leaving you with less money to spend during your retirement years.

Legislative Risk

Legislative risk pertains to the structure of the U.S. tax code. This is the risk that the government may pass new legislation that negatively impacts your retirement savings vehicles or approaches.

Although these two risks are closely related, they can affect your retirement approach differently depending on how you save and spend in retirement.

Addressing Tax and Legislative Risk Now

Given the current economic and legislative climate, it’s crucial to address tax and legislative risks sooner rather than later. Consider the following points:

• The national debt has swelled to over $34 trillion, prompting many experts to believe that Congress will need to raise additional tax revenue in the near future.
• Congress has passed significant new spending priorities in recent years, potentially requiring increased tax revenue to offset this spending.
• Recent Congressional debates indicate that retirement accounts are one area where lawmakers are looking to generate additional tax revenue.

Four Potential Legislative Impacts on Your Retirement

1. Changing Tax Brackets

• Congress has historically adjusted U.S. tax brackets, impacting both the income that falls within each bracket and the tax rate applied to that income. For instance, the tax reforms introduced in 2017 (commonly known as the Trump Tax Cuts) temporarily lowered tax bracket rates, but these changes will expire in 2025, reverting to older, higher rates. This could mean higher taxes on your retirement income starting in 2026.

2. Limiting Tax Deductions

• Legislation in recent years has reduced or eliminated various tax deductions. Changes to tax deductions can significantly affect the amount of your income that is subject to taxation. For example, the 2017 Federal Tax Reform eliminated some deductions, and further reductions could be enacted in the future.

3. Adjusting Which Assets Are Taxed

• The government can change which retirement assets are taxed through new legislation. An example is the taxation of Social Security benefits, which became taxable in 1984. Further increases in taxable portions of benefits could be enacted, resulting in higher taxes on your retirement income.

4. Changing How Assets Are Taxed

• Congress can also change the rules on how retirement savings accounts are taxed. Recent debates have included proposals such as new Required Minimum Distributions (RMDs) for qualified retirement accounts, which could force withdrawals and taxation on those funds under new rules.

Protecting Yourself from Tax and Legislative Risks

Different retirement savings vehicles have varying levels of exposure to tax and legislative risks. Diversification within your retirement strategy can help mitigate these risks. Some savers incorporate tax-free vehicles like Roth IRAs and Roth 401(k)s into their strategies to hedge against rising taxes, as these accounts are funded with after-tax dollars and are not taxed upon withdrawal.

Additionally, to address legislative risk, some savers diversify beyond traditional and Roth accounts, opting for vehicles with lower exposure to legislative changes, such as annuities or cash value life insurance.

Take Action Now

It’s essential to work with a financial professional who understands tax and legislative risks and can help you make informed decisions based on your retirement goals. If you’re concerned about these risks, start preparing now. Discuss with your financial professional:

• The likely trajectory of your taxes in retirement.
• How different tax scenarios could impact your retirement income.
• Whether your current retirement savings vehicles expose you to legislative risks.
• How potential legislative changes could affect the legacy you plan to leave.

By evaluating tax and legislative risks, you can better prepare for the complete range of challenges you may face in retirement, helping you achieve the retirement you’ve envisioned.