Investing for retirement is the main reason many people buy mutual funds. It is why funds have become the hottest investment in retirement plans such as 401(k)s.
Retirement investing is also a highly competitive area for fund companies, which want to lock up as many of the billions of savings dollars as they can.
One way companies vie for that business is by providing retirement planning information that helps people determine how much they must save to meet their goals.
But often the tax assumptions in those workbook and computerized retirement guides create the impression that retirees will pay higher income taxes than they actually will.
So if your planning guide tells you to use 28 percent as your tax rate when planning the amount of income you will need in retirement, you can ignore it, unless you have a lot of money. You will probably not pay anywhere near that.
Some advisers don't consider overestimating taxes a problem, arguing that using the wrong rate may only create a pleasant surprise when you retire because you'll have more than expected.
But if you don't think you will be saving enough to reach the numbers projected by the plan because you estimated your taxes too high, it could cause fear that you won't be able to retire when you want.
It could also lead you to make more aggressive investments than you are comfortable with in an effort to close a nonexistent gap.
"People have been overtaxing themselves when they figure out how much income they will have in retirement," said Steven Norwitz, a vice president at T. Rowe Price.
That higher rate is the marginal tax rate -- the rate on the last dollar of income -- which overstates the average rate you would pay.
Now, T. Rowe Price, which offered one of the first mutual fund retirement planning kits in 1989, has modified its retirement planning software to indicate that the rate people pay is much lower than the rate usually projected.
T. Rowe Price has programmed into the latest version of its planning kits data from the Tax Foundation, a private, nonprofit educational group in Washington.
For example, the data indicates that a New York state couple in the $45,000-to-$60,000 income range will on average pay 8.7 percent of their income in federal taxes and 4.5 percent in state taxes.
The 8.7 percent rate is on ad- justed gross income, which doesn't take into account major deductions, so your actual taxable income and the effective tax rate may be a lot lower.
A single taxpayer in the same income range averages 13.2 percent in federal and 5.5 percent in state tax, according to the foundation's study.
The difference between using the marginal tax rate to determine your disposable income in retirement and using your effective rate can be large. The effective rate is your taxable income divided by the actual taxes you pay. So without changing what you are saving now -- and you shouldn't necessarily decrease that because of what tax calculations tell you -- you may find you are in better shape than you thought.
But do your own calculations. Don't depend on averages be- cause your income and deductions may differ radically from the averages.
For example, assume that income from your pension (if any), Social Security and whatever you draw from your retirement investments such as IRAs or 401(k)s will produce $50,000 a year of family income when you retire.
If your planning determined that the entire amount will be taxed at a 28 percent rate, you would owe $14,000 in taxes. That is what some planning programs would show.
But it is wrong for two reasons. The first is that the entire $50,000 is not taxed at 28 percent, only the last $8,800. The first $41,200 is taxed at 15 percent. (That is what is meant by a graduated income tax.)
The total you really would owe is $8,644 -- a difference of $5,356 a year, or more than $100 a week, which should make some difference when you retire.
But even that number is wrong. The Tax Foundation data indicates that the 8.7 percent in federal taxes, based on adjusted gross income, means a federal tax bill of only $4,350, instead of that original calculation of $14,000.
But the Tax Foundation's figure is the average for all tax returns filed in 1996 based on adjusted gross income -- which is easier for the group to use, and for most people is close to gross income. Taxable income -- which includes deductions for personal exemptions, medical costs, state and local income taxes, property taxes, and mortgage interest -- is usually a lot lower.
So what you should use is your effective tax rate. That is a variable number, which will change annually as your income and deductions change. You can figure it by looking at your tax returns.
"If you aren't using a professional, the way to figure it out is to project your actual income and taxes with deductions for the next 10 or 15 years on an annual basis," said Alan Weiner, a partner in Holtz Rubenstein DFK, an accounting firm in Melville, N.Y.
But Weiner said he wasn't too worried about people using the marginal tax rate because "you are making a very safe assumption because if you overestimate, you are going to be able to count on the surplus."
Pub Date: 8/10/97