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

Not much I can say about this one, a picture’s worth 1000 words….. enjoy the weekend!
Joe

written by JOE \\ tags: cartoon, JoeTaxpayer, Social Security

I recently read a post “Why I love Roth IRAs” in which the author ignores much of the math going in and coming out. Now, I love Roths myself, but only when used to take most advantage of the tax rates involved. Let me explain. From my feature article earlier this year titled “Can you save too much, pre-tax?” we see that a couple with $447,500 in their 401(k) or Traditional, Pre-Tax IRA, can take withdrawals and remain in the 0% bracket. This is due to the combination of standard deductions and exemptions. The next $401,250 will support withdrawals at the 10% rate.
If you have a defined benefit pension (a traditional pension) the numbers certainly will shift, and you need to take this income into account. Pensions are getting more scarce and those who frequently changed jobs are likely to have never vested into any one plan.
So, now I’ll ask, what percent of retirees are likely to have saved this sum, a total $848,750 from the numbers above? I cite an article from AARP titled 2004-05 Boomers which offers a forecast. One chart in this report offers that for those born in 1956-65, their mean (this means average, important distinction from median, middle) wealth is forecast to be $839K. But reading on, we find that after subtracting non-retirement wealth and present value of Social Security benefits, we are looking at a retirement account balance of just $140K. It turns out the 4th quintile (this is the second 20% from the top) is forecast to have $906K, this scales to about $151K in retirement accounts. Even the top quintile (top 20%) will average $2028K total wealth, with maybe $350K-$400K in retirement accounts. So it’s only the upper portion of that group (in addition to those with fat traditional pensions) that need to consider the Roth while working. For the rest of us, we will likely be in the 10% or if fortunate, the 15% bracket upon retiring.
I’ll close with this thought - each family has their own set of numbers. This is why if you write in to a web site or magazine and ask “Is Roth good for me?”, it’s impossible to answer without knowing many details. We know more the closer you are to retirement, but only have a series of clues the further away you are. Another blog “The Finance Buff” offers a view similar to mine. I remain surprised at how many wave the Roth flag without some level of analysis. For those who have access to a Roth 401(k) and Roth IRA, it would be a shame to load those up and find that they missed out on the tax savings that pretax savings could have provided.

Joe

written by JOE \\ tags: 401(k), Finance, income, IRA, Retirement, retirement account, roth ira, saving, Savings, Social Security, tax, tax rates, traditional pension, wealth

Earlier this week, I talked a bit about the Social Security replacement rate, how much a single person could expect to receive at their normal retirement age. As we discuss trying to make up the difference to enjoy a post retirement income which replaces working income by close to 80% we run into the Social Security tax trap, the fact that for a single person, when half your benefit plus other taxable income exceeds $25,000, the benefits become taxable. So I updated the table a bit.

Now we can see the amount of (taxable) income we can have before we hit the range where SS benefits are taxable. We also can see the amount of money needed to generate that income (using the 4% withdrawal rate we’ve discussed in the past). Note: The column “$25K-1/2 Benefit” is increased by $8950, the sum of the standard deduction and exemption for a single person. Of course if you have high enough deductions to file schedule A this will increase further. So, getting back to the discussion of pretax and post tax savings, we are closing in on the gross numbers you can save, pretax, with little risk of either hitting a higher tax bracket at retirement or running into the range where Social Security benefits are taxable. In the next few weeks, I will offer more analysis, along with observation on this scenario for couples.

Joe

written by JOE \\ tags: Finance, Investing, money, Retirement, Savings, Social Security

I’ve had more frequent conversations recently regarding a number of financial topics. The pretax vs post tax IRA certainly tops the list along with the required income needed at retirement, both in absolute terms as well as replacement ratio. I thought this would be a good time to discuss how much of that retirement income is expected to come from Social Security. The primary insurance amount (the benefit (before rounding down to next lower whole dollar) a person would receive if he/she elects to begin receiving retirement benefits at his/her normal retirement age) is shown below for those with annual incomes ranging from $20K per year to $90K per year.

A few observations here: This reflects the benefit an individual would receive, and my comments for tax purposes also reflect one filing single. The way this is calculated, a lower wage earner receives a higher percent of his income at retirement than a higher earner. If we use 80% (not saying I agree or disagree, but 80% keeps popping up) as a target replacement income, the $55K earner will have half of this target covered by Social Security. In my next post, I’ll discuss the Social Security Tax trap, and tie the analysis back to the pretax vs post tax investing decision.
Joe

written by JOE \\ tags: Finance, Investing, Retirement, Social Security

George Will had an article in the May 5 edition of Newsweek titled “Questions for Obama“. One question was;

“You favor eliminating the cap on earnings subject to the 12.4 percent Social Security tax, which now covers only the first $102,000. A Chicago police officer married to a Chicago public-school teacher, each with 20 years on the job, have a household income of $147,501, so you would take another $5,642 from them. Are they undertaxed? Are they rich?”

I have a question for George - Do you know the $102,000 FICA withholding cap is per person, not per family? If a couple each makes the same income, their current total cap is $204,000. So your Chicago couple would need quite a few raises before they even come close. In 2005 (last census numbers) shows that only 2.67% of households made more than $200,000. Now, how does that impact your view on eliminating the FICA withhold income cap?

JOE

written by JOE \\ tags: fica, Finance, george will, newsweek, payroll tax, Social Security

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

I’ve updated my main site with an article titled “Can you save too much, pre-tax?” The topic can use a bit more analysis, but in general, it’s tough to save your way to the next tax bracket at retirement.
May 2008 bring you health, happiness, and wealth, in whatever order you prefer.
JOE

written by JOE \\ tags: Finance, Retirement, roth ira, Social Security, Taxes

Or “your tax guy is not your planner*”. Last month, I posted on Year End Planning and offered a couple thoughts for issues that need to be addressed before 12/31. As I thought more on this topic, it occurred to me that many people use a paid tax preparer, and while I have no issue with this, keep in mind that unless you have a November visit with your tax guy or planner, you will find that most things you might have done to optimize your finances have passed the 12/31 deadline. I mentioned charitable donations, specifically, that 2007 is the last year you may opt to donate money directly from your IRA if you are over 70-1/2. I also discussed converting some of your IRA to a Roth.

This is also the time to make sure you’ve taken the RMDs (required minimum distributions) from your IRA if you are 70-1/2 this year.

Also to think about at year end, is to review your portfolio and determine whether any rebalancing would be appropriate. I am a believer in long term investing, but a regular look at your portfolio composition is important. For the working investor, you may choose to balance as you go, making new purchases to keep each asset class at its targeted level, or for the retiree, to take withdrawals from the class which has become overweighted.

Tallying up your gains and losses for year can also help. Say you have a short term gain of $5000, which would be taxed at your standard rate (the same tax bracket as ordinary income). You may find a stock you are holding onto at enough of a loss to offset that gain. If you still wish to own that loser, you can either double up, more than 30 days prior to the sale, or buy it back 30 days after the sale, to avoid wash sale rule disqualification.

Your employer is probably advising you that any changes to your Flexible spending account and Dependant care account are due shortly. If you participate, go do the math. If not, review the details of these two programs, as the savings can really add up.

This is a good time to evaluate your 401(k) and IRA savings level. I read that 20% of people with access to a 401(k) do not deposit enough to capture the matching funds. I view that as money down the drain.

(As always, I welcome all comments, and suggestions if I’ve missed any key points)
JOE

*well, he may be. My point is just that there are a number of decisions to make well before you bring your box of statements to the tax man.

written by JOE \\ tags: Finance, Retirement, roth ira, Social Security, Taxes

I wrote about the high Phantom Rates one may encounter due to the taxation on Social Security benefits, and I continue to receive positive feedback on that article.

I received two questions which I thought appropriate to address here.

Is there an age after which you can earn as much as you want and the phantom tax does not apply?

If you are under ‘full retirement age’ $1 in benefits are lost for each $2 you earn above $12,960. That’s quite a hit, and someone who is working should think about whether it makes sense to draw any benefits earlier than full retirement age. Note: full retirement age changes based on the year you were born. The Social Security web site has a link to see your retirement age.

Do you count passive income the same as earned income when doing these calculations?

For the phantom tax bubble I illustrated, I show either earned income or 401(k)/ IRA withdrawals which are taxed the same. Dividends or Capital Gains have their own curves which are unpleasant in their own right, the marginal rate appearing to be 32% on what should be 5% rate dividends. The best advice is to go to www.ssa.gov which is an easy site to navigate, and to buy a copy of TurboTax, and run your own scenarios. To produce those charts, I set a fixed SS payment, changed income by $1000 increments, and charted the numbers. I offered two examples, one from experience, the other at a reader’s request. The tax software will make your exact situation clear to you. JOE

written by JOE \\ tags: Retirement, Social Security, Taxes