Why are first year taxes so strange?

There are two things an advisor or client might want from tax estimates in the first year of their retirement plan:

1. An accurate set of tax calculations, based on the actual timing of income and expenses
2. A general feel for the net-of-tax income available in the plan, smoothing out the effects of one-time or lumpy spending and income

Both of these are reasonable things to want, but for many realistic client situations, they cannot both be done at the same time. Income Lab software provides tax estimates in approach #1. That means that calendar year totals are used to produce tax estimates. While this is positive for those who want accuracy and attention to detail, it isn't without problems.

A few things can make the answer to #1 less than helpful for those who are hoping for an answer along the lines of approach #2.

1. A mid-year retirement
2. Large, one-time, or lumpy expenses or income streams in the year of retirement

Either of these situations can lead to a problem for those viewing net income in the first year of retirement on the main plan dashboard.

Mid-Year Retirement

For example, if the income plan begins not in January, but in the middle of the year, any pre-retirement income and wages can lead to a higher tax on partial-year retirement income. Take a plan to retire in September, with pre-retirement wages of $15,000/month and retirement withdrawals from an IRA are $9,000/month.

Total income in the calendar year of retirement is $156,000. All of this will be taxed as ordinary income (and the wages would be subject to FICA tax). For a 65-year-old single taxpayer with a standard deduction of $14,600 + $1,950 = $16,550 in 2025, this leads to $139,450 in taxable income, which puts the taxpayer into the 22% bracket. However, if the entire year had contained only $9,000/month withdrawals, taxable income would have been $91,450 (the 12% bracket). So, it would be hard to generalize these taxes to future years. Doing so would likely overstate them.

Conversely, if you fail to include pre-retirement income, this plan could have contained only the $36,000 in IRA withdrawals in the first year, with no other income, thereby understating taxes that would be encountered in future years. On balance, it is typically better to include pre-retirement income in the plan.

To avoid letting pre-retirement wages and earnings affect retirement income in the year of retirement, it can be a good idea to set retirement in the month of January, if possible.

Lumpy Income and Expenses

However, even if retirement is in January, lumpy one-time or irregular expenses or income can also affect net retirement income estimates. Again, this is due to the fact that Income Lab software uses full calendar year totals in tax estimates. So, for example, if the first year of retirement includes $1 million in proceeds from the sale of a business, or $500,000 in extra IRA withdrawals to pay for the purchase of a vacation home, this additional taxable income will lead to increased taxes and tax brackets for that calendar year. This is correct for approach #1. However, it distorts the view of approach #2.

If you are most interested in tax approach #2, it may be best to avoid these distortions by putting large expenses or income flows in years other than the first year of retirement, if at all possible.