Getting the taxman out of your retirement — Part 1

One of the most overlooked, but perhaps most important, aspects of retirement income planning is taxes and how they relate to Social Security. Taxation on Social Security benefits works differently than other income sources; because of this: far too many people unknowingly fall into a preventable tax trap with their tax-deferred retirement accounts such as 401(k)s, 403(b)s, 457s, IRAs, etc.

Even if you are in a lower tax bracket in retirement, you might end up paying a higher tax rate on withdrawals from these types of accounts. Even if Social Security seems like a distant worry, it’s wise to begin mapping out a plan to neutralize future taxation on it as soon as possible.

To explain how you can end up paying a higher tax rate on retirement income while in a lower tax bracket requires a bit of a history lesson on how taxation of Social Security works.

 

Social Security and Taxes – a brief overview

In 1984 taxation began after Social Security amendments were passed the previous year. At that time, less than 10% of those who were receiving Social Security actually had those benefits subjected to taxation. That number has increased a shocking fivefold over the years.  The reason lies in the unchanged formula called modified provisional adjusted gross income used to determine how much, if any, of one’s Social Security is taxed.

This is calculated by taking half of what your Social Security benefits are then adding that number to all of your other income such as dividends, interest (including interest from municipal bonds), pensions, other income, tax-deferred retirement account withdraws, etc. If you’re single and that number is under $25,000, there’s no tax. If you’re married, you encounter a marriage tax penalty since the number is only $32,000, which is a mere 64% of what is should be if the $25,000 single number were doubled to $50,000. Regardless, for every $1 of income you have over these amounts causes $0.50 of your Social Security to be taxed.

Starting in 1994, a new additional tax bracket was added. I call this the Al Gore tax since the senate was split 50/50 on legislation that would add this extra tax and as Vice President he cast the tie-breaking vote. This new bracket made it so once you hit $34,000 single and $44,000 married with the same formula, the taxation becomes far heavier. Every $1 you are over these numbers causes $0.85 of your Social Security to be taxed. This continues until 85% of your Social Security benefits become taxed. When you reach the maximum 85% limit will be different for everyone since it is contingent on how much of your income is Social Security and how much is from other income sources.

These thresholds made in 1983 and 1993 have never changed, unlike regular income tax brackets that increase each year to take inflation into account. Clearly, $25,000 and $34,000 in 1983 had a much different buying power than today. Because these threshold numbers have never changed, more and more filers each year have their Social Security subjected to taxation as income levels rise with inflation.

 

Tax-deferred accounts – a potential problem

With tax-deferred accounts, you don’t pay any taxes when the money goes in or as it grows, but you have to pay taxes when you withdraw the money. Every dollar taken out counts as $1 of income on your tax return.

Unfortunately, if you’re a married couple sitting right at the $44,000 threshold and decide to take $1 out of your IRA, 401(k), or other deferred retirement accounts, not only would you pay taxes on that $1, but it would also cause $0.85 of your Social Security to be taxed that otherwise wouldn’t have been had you not taken that $1 out of your account and raised your income by $1. At current tax rates, this would mean you would pay a 12% tax on that $1, which equals $0.12, plus a 12% tax on the $0.85 of your Social Security that was taxed because you took that $1 out, which equals $0.102 — taking that $1 out of the retirement account cost a total of $0.222 (22.2%) on that $1!

 

Looking forward

As the tax brackets stand today in 2019, a single person taking standard deduction can have up to $51,675 in income before moving from a 12% tax bracket to a 22% tax bracket; for married couples, this number is doubled to $103,351.

Conventional thinking suggests if you exceed these amounts and are paying a 22% tax rate, it may be beneficial to put your money into a tax-deferred retirement account like a traditional 401(k) or IRA to avoid paying this tax now. By doing so, you could wait until your income is lower in retirement and you’re in a 12% tax bracket to pay taxes. As we’ve demonstrated, though, you might be in an unfortunate situation where you’ll actually pay a 22.2% tax on that money when it comes out even if you’re in a 12% tax bracket. If the current 12% and 22% tax brackets revert back to 15% and 25% in the future as they were before the supposedly temporary Trump tax cuts, you could easily find yourself paying a 15% tax on $1.85 for every $1 you take out, which works out to be an alarming 27.75%.

If you want to avoid potentially paying over double the current tax rate later in life, check out part two next month, where we explain a few strategies you can implement to possibly eliminate this scenario from happening – regardless of if you’ve already started Social Security or not!

–Ryan Shumaker, Smartvestor Pro at The Retirement Team (Reprint from Forbes.com BrandVoice) 

 

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