Social Security & Progressive Taxation

Transcription

1 Social Security & Progressive Taxation There are two sections to this software. The first deals with taxation of Social Security. The topic of the second section is progressive tax rates. You go from one part to the next by clicking the gray button located at the bottom right of the screen. There are a total of 5 screens in each part, which are represented by the 5 buttons you see at the top of the screen. 1

2 By default this section opens in the part that deals with Social Security taxation. (Before clicking a button you might say something like ) One of the biggest mistakes that people make as they prepare for retirement is to ignore future taxation and the potential advantages of tax diversification. By balancing retirement savings so that some is taxed currently, with some the taxes are different and some tax free, it may be possible to reduce how much of your future income is lost to taxes. This is important because most people think that the only way they can increase future retirement income is to save more or invest better. An equally important factor is being tax efficient. It is easy to see why by considering Social Security taxation. Most people are not tax diversified, which means that at retirement they have only two primary sources of income; one is Social Security and the other is what they have saved in their IRAs, 401k or other tax deferred retirement plans. During retirement we will all need a certain amount of income to pay our bills and enjoy ourselves. So let s say that this circle represents our total needed income. 2

3 Part of this needed income is met by Social Security, and in this example it is the blue portion. What is interesting is that if this was our only income, none of it would be taxed. The reason is because of the way that Social Security taxation is calculated. 3

4 (Refer to the container on the right.) Think of all of our retirement income as going into a container. Once the total income exceeds certain thresholds, a greater portion of our Social Security benefit become taxable. If our only income was from Social Security we would be below the first threshold so our benefits would be entirely tax free. The challenge is that if all we had was Social Security, we would not have a very enjoyable retirement. We need more income and fortunately most people have saved (or are saving for) retirement. The problem is that many have concentrated on only saving in tax deferred accounts. When our only other source of income is our IRA, or 401k plan we have no choice but to withdraw from those funds 4

5 (Click button #1 at the top of the screen.) for any additional income we need, that is represented by the pink section in this example. And this can set off a series of negative tax treatments because when we add withdrawals from an IRA to Social Security, for many people the total will likely exceed the first tax threshold and possibly the second as well. Any amount over the first threshold becomes 50% taxable. Any amount over the second adds another 35% for a total of 85% that is taxable on that portion. 5

6 Tax treatment over that second threshold is so severe that many people want to do anything possible to avoid it. (Click button #2) One possible way to accomplish this is by limiting your IRA withdrawals so that the total does not exceed that second threshold. In other words only withdraw an amount from your IRA or 401(k) that takes you right up to but not over this top threshold. While this could allow you to avoid the higher taxes on Social Security, the problem is that you will likely need more income to enjoy your retirement. 6

7 So the important question is if there is a way to get the income you need and want without exceeding that second threshold? Fortunately, the answer might be yes but only for those who have prepared. People who have followed the principal of tax diversification will not put all of their money in tax deferred accounts. (Click button #3) Instead, they build a third source of future income in a tax advantaged account. When they need income in the future, they try to limit withdrawals from their IRA so that the total, including Social Security does not 7

8 exceed the top threshold. Then they fill any gap between what Social Security and IRA withdrawals provide by taking withdrawals from their tax advantaged money, in this example the green portion. As I explain this to clients, I am often asked if it is possible to reduce or avoid the (Click button #4) 50% taxation of Social Security benefits when income exceeds the first threshold? While it is more difficult, it might be possible if the only two sources of retirement income are Social Security and Tax Advantaged money. But, the principal we are discussing is diversification. Which means that we are looking for more of a balance of tax treatment. People who have only used the traditional IRAs and 401k plans to save for retirement might want to consider strategies for either 8

9 (Click button #5) diverting or converting some of that money to some tax advantaged alternative. We can discuss these options later if this is of interest to you. (Click the grey button at the bottom labelled Taxable Social Security. This will change to the Progressive Tax section.) 9

10 The potential advantages of tax diversification can go beyond reducing taxable Social Security. With enough preparation, it may be possible to reduce overall income taxes while in retirement as well. Our tax system is referred to as progressive which means that the greater your taxable income, the tax rates applied progressively go higher. There are retirees in this country whose only source of income is their Social Security. 10

11 Many of them pay no income tax at all because they are below the thresholds for taxation of Social Security benefits and they don t have sufficient income to reach the first tax bracket. Of course the problem is that they also don t have enough income to really enjoy their retirement. Others have saved during their working years so that they can have more income when they retire. The problem for them might be that they have put all of this savings into their IRAs and 401(k)s. They aren t tax diversified. To get extra income their only option is to withdraw from their IRA. (Click button #1) The amount they withdraw will determine how high a rate of tax they will be exposed to. Again, it might help to think of your income from all sources as filling up a container. The level that is reached will determine your highest tax rate. In this example, the blue portion of the container represents Social Security and the pink represents withdrawals from an IRA. Income up to this first level is tax free. Income exceeding this first level up to the next is taxed at a rate of 10%, then the excess up to the next level is taxed at 15%. The excess over each level get taxed at a progressively higher rate. 11

12 (Click button #2) However, if you could limit your IRA withdrawals, it may be possible to limit the tax rate that is applied. Again, the problem is that we might want more income so that we can enjoy ourselves. So the question is can we have more income but at the same time keep our tax rates low? The answer is that this may be possible (Click button #3) if we have saved some of our retirement funds in a tax advantaged vehicle as opposed to having all of our savings in an IRA or 401K. 12

13 Preparing for this by building a tax advantaged source of income could allow you to enjoy the income you need and still limit the taxes you pay. (Click button #4) Again, in extreme circumstances it may even be possible to eliminate all taxes if the only funds were from Social Security and tax advantaged sources. But the point is that it is not necessary and could be unwise to go to extremes. Instead, there can be a great value in preparing in advance to achieve tax diversification. As mentioned before, people who have only used the traditional IRAs and 401k plans to save for retirement might want to consider strategies for either 13

14 (Click button #5) diverting or converting some of that money to some tax advantaged alternative. -END- 14