JoeTaxpayer

Some time ago, in an article titled Social Insecurity, I wrote about what I call Phantom Tax Rates. To understand this, one first must understand what one’s Marginal Tax Rate is. A single person, after taking his exemption, and deductions, will pay 10% of the amount up to $16,050, then 15% from $16,050 to $65,100, then 25% from $65,100 up to $131,450. Let’s stop there. The Phantom Tax Rate comes into play when there is either a phase out of deductions or phase in of other income. In the case of Social Security, when half of your Social Security benefits plus other income exceed $25,000 ($32,000 if married filing joint) your benefits start to become taxable, until 85% of your benefits are fully taxed. This create a graph that looks as follows;

While we would expect a 15% rate from $16,050 right to $65,100, instead we find that for each $1000 of income (or IRA withdrawals for the person for whom this chart applied) that the incremental tax is as high as $462.50.

In another situation, the adoption credit is phased out for AGIs between $174,730 and $214,730, and in the case I’ve been alerted to, the taxpayer loses $11,600 on the next $40,000 of income due to this phaseout. This loss, plus his marginal rate of 25% total 54.13%. My advice to him was to defer income if possible to 2009, which he will. By deferring that $40,000 worth of income he will pay $26,600 less tax this year, and just $10,000 when he receives this income in 2009.

When it comes to taxes, nothing is simple. When planning, it’s best to get a copy of TurboTax and run a few ‘what-if’ scenarios to best understand the impact of any financial changes you may incur.
Joe

written by JOE \\ tags: adoption credit, income, IRA, irs, marginal tax rate, phantom tax rate, social insecurity, Social Security, tax rates, Taxes

For my first post of this year I wrote an article titled, “Can you save too much, pre-tax?” This is a topic that comes up frequently as one decides whether to choose a Traditional (pre-tax) IRA vs a Roth IRA. I recently had some dialog with another blogger and it’s clear to me that the decision is not so clear cut. Ideally, one makes a deposit pre-tax and withdraws it at a lower rate some time later. But as Mark (the other blogger) reminds me, a Roth has many benefits that shouldn’t be ignored:

1. You can withdraw the original deposits at any time with no tax or penalty, as I suggested in my Roth magic post.
2. A Roth has no RMDs (required minimum distribution) requirement, which forces withdrawals when they may not be needed or wanted due to other considerations.
3. The accounts pass through one’s estate with less impact to estate tax as the funds are denser, and received by the beneficiary with no income tax upon withdrawal.

I think for any retiree there is likely an ideal mix, so they might draw funds from their pre-tax accounts (IRA and 401(k)) and use Roth withdrawals to avoid getting sent into the next bracket or be subject to the Social Security Tax Trap. The issue today is that we can’t know that mix two or three years out, let alone 20 or 30. What I do know, and I hope Mark agrees, is that this decision follows the shape of the Laffer Curve. I know with certainty that 100% of one’s savings in pre-tax accounts misses the benefits I share above. 100% in Roth accounts will miss the benefit of the zero bracket I discussed at length in my article cited and linked above. I don’t know the ideal mix, but I’d suggest this: The lower your savings rate, the more you’ll see the benefit of pre-tax savings, a diligent saver may be best served by leaning toward the Roth savings. A Wall Street Journal article titled “A Cool Million No Longer Buys You a Luxe Retirement” helps back up my position as it states that only the richest 2% of Americans have saved more than $1 million. One would need to be in this exclusive group to even begin worrying about higher taxes on the their retirement savings. I hope to get some feedback, as others’ opinions always help me to see a different side of the issue.

Joe

(update - are you feeling lucky? The Google search for “pretax vs post tax ira” (leave off the quotes) will lead right to this post. Could just be the choice of words? Or maybe I’m just lucky?)

written by JOE \\ tags: 401(k), Finance, marginal tax rate, money, Retirement, roth conversion, roth ira, Savings, Social Security, Taxes