Chapter 2
Taxing Issues
IN THIS CHAPTER
Understanding why you get tax breaks
Getting a handle on tax terms
Taking credit when you can
Scoping Social Security issues
Paying taxes before and after you retire
Being prepared for changes in the tax code
It’s up to you — no one else — to plan for a successful retirement. Government policy makers want you to have the resources to retire successfully so that you don’t become a burden to society. With that goal, the government gives you and your employer tax incentives to encourage you to save and your employer to offer retirement plans to make saving easy.
This chapter talks about the whys and hows of taxes as they relate to retirement accounts.
Realizing the Reasons for Tax Breaks
I hope it’s not news to you that Social Security was never intended to provide an adequate level of retirement income. The additional amount you need to retire comfortably must come from other sources. Lawmakers encourage setting aside money for retirement by providing tax breaks and incentives.
What the government gains
Society is stronger if older people are financially secure. Having sufficient resources to provide for themselves eliminates the need for federal and state governments to sustain senior citizens via Medicaid, food stamps, subsidized housing, and other programs.
If people are forced to continue working into their seventies and eighties, that makes it more difficult for teenagers and other younger workers to find employment because both groups are likely to compete for jobs in the service and retail industries.
Having money to spend beyond the bare necessities — going out to eat, buying a new car (even if it’s just new to you), taking vacations, and engaging in other leisure activities — boosts the economy, which in turn provides employment to other workers.
Retirement saving is good for seniors and good for the country.
What you gain
By participating in a retirement saving plan, you do yourself several favors:
- You put away money so that you can enjoy your retirement without financial worries.
- If you can contribute pre-tax wages, you put off paying taxes until you spend the money. You may even work for an employer that adds money to your account. I talk about 401(k) plans in Part 2.
- You can deduct qualified traditional IRA contributions when you file your taxes.
Saving so that you have money to live on in your later years is its own reward. Being able to kick back and enjoy the fruits of many years of labor is part of why you work in the first place.
Benefiting from tax advantages while you save is the icing on the retirement cake. The next sections touch on these.
Benefiting from an employer-sponsored plan
Some folks can take advantage of employer-sponsored retirement benefit plans. Most public employers still offer traditional pension plans that provide a stream of monthly lifetime pension income.
If you’re self-employed, you can start your own retirement plan — the chapters in Part 5 offer information on small business plans.
You can put 25 percent or more of your earned income into an IRA-based retirement plan. If set up properly, you can save federal and state income tax, local wage tax, as well as Social Security tax. The combined tax savings if your marginal federal income tax rate is 22 percent will be 40 to 50 percent of the amount you save. A $10,000 contribution can produce $4,000 to $5,000 of tax savings.
You’re one of the fortunate ones if you’re covered by an employer-funded non-401(k) plan, also known as a pension. There are two types of employer-funded pension plans:
- Traditional defined benefit plan: This type of plan pays a lifetime monthly income after retirement. The plan isn’t very valuable unless you spend a lot of years working for the same employer. The value of the benefits you earn are low during your twenties and early thirties. The value of the benefit you earn during your twenties is usually less than $1,000 per year if you earn $50,000 annually. The value increases the longer you stay and the closer you get to retirement.
- Cash balance plan: In this type of plan, the employer contributes a specific percentage of pay for younger employees — typically 3 percent, so $1,500 per year if you earn $50,000 annually. You may have to stay with the employer for three years to get this benefit.
Deducting IRA contributions
If you work for an employer that doesn’t offer any plan, you’re probably eligible to contribute to an IRA. You can contribute $6,000 annually if you are under age 50 plus an additional $1,000 if you are age 50 and over. You can deduct the amount you contribute on your Form 1040 when you file your tax return. These are the 2021 limits.
You may not be eligible to contribute to a traditional IRA if your spouse is covered by an employer-based retirement plan. See “Paying attention if your spouse has a plan” later in the chapter.
Talking Tax Terms
Being an effective and efficient manager of your own money means being familiar with taxes and tax terms. The next sections explain common tax terms it pays to be familiar with, particularly when dealing with an IRA.
Earning your income
Earned income includes the amount you receive from working for someone. Wages, commissions, tips, bonuses, and taxable fringe benefits all count as earned income, as does income from running a business or a farm.
Earned income may also include untaxed military pay, taxed alimony, and disability benefits. Untaxed alimony, child support, Social Security benefits, unemployment, and wages earned by penal institutional inmates are excluded. Your contributions to an IRA can’t exceed your earned income except for contributions to a spousal IRA that come from the employed spouse’s earned income.
Combining your income
Your combined income is what determines how much of your Social Security benefit is taxable.
Your combined income is the total of
- Your adjusted gross income
- Your nontaxable interest
- Half your Social Security benefits
Adjusting your income with AGI
Whether it rings an immediate bell or not, you’re familiar with figuring your adjusted gross income (AGI) at tax time. The IRA defines AGI as “gross income minus adjustments to income.” Your AGI is equal to or less than the total amount of income you had for the tax year depending on the adjustments you’re allowed. Income sources that contribute to your AGI include
- Wages on a W-2 or 1099 form
- Self-employed income on a Schedule C
- Interest and dividends
- Alimony from an ex-spouse (for agreements prior to 2019)
- Capital gains
- Rental income
- Retirement distributions
- Other earnings subject to income tax
By the time you get to the bottom of the first page of your tax form, you have figured your AGI.
You have many opportunities to take tax deductions on your tax return. Some deductions reduce your income to determine your AGI; these are referred to as adjustments to income. Some current permitted adjustments to your AGI include educator expenses, student loan interest, and IRA contributions. But be aware that tax laws change every year.
Your modified adjusted gross income, or MAGI, is your AGI plus specific add backs of untaxed income. For example, you aren’t taxed on foreign investment income, but your MAGI includes that income.
In a nutshell, your AGI reflects your income; your MAGI is a more complete picture of your financial resources. It’s confusing and one of the many reasons I don’t prepare my own tax return.
Figuring your marginal tax rate
The United States has a graduated tax structure rather than one flat rate in which all taxable income is subject to the same rate. Your income is subject to different tax rates. Your tax rate increases as your taxable income increases.
The more your taxable income, the higher your taxes. You pay a lower rate on the bottom tier of your earnings and pay increasing rates on higher amounts. Table 2-1 shows tax tiers for 2021.
So, if you’re single and have $75,000 of taxable income, you pay 10 percent on $9,950, 12 percent on $9,951 to $40,525, and 22 percent on $40,526 to $75,000. So, 22 percent is your marginal tax rate — the rate you pay on the top portion of your income.
TABLE 2-1 2021 Tax Tiers by Income
Single with Income Up To | Married Filing Jointly with Income Up To | Tax Rate |
|---|---|---|
$9,950 | $19,900 | 10% |
$40,525 | 81,050 | 12% |
$86,375 | 172,750 | 22% |
$164,925 | $329,850 | 24% |
$209,425 | $418,850 | 32% |
$523,600 | $628,300 | 35% |
over $523,600 | over $628,300 | 37% |
Source: Internal Revenue Service
Getting Credit for Contributions
You get an immediate tax break when you make pre-tax contributions to a 401(k) because your taxable pay is reduced by the amount you contribute. You actually authorize your employer to reduce your pay when you join a 401(k). The taxes withheld are reduced; therefore, the reduction in your take home pay is less than the amount you decide to contribute. You don’t get this advantage with Roth contributions to your 401(k) because they’re post-tax contributions.
Deducting IRA contributions
You get a tax reduction when you contribute to a traditional IRA and you file a tax return: Your taxable income is reduced by the amount you contributed. You may also get an additional tax benefit via a tax credit from the government.
If you’re covered by a retirement plan at work, use the information in Table 2-2 to see whether your modified AGI affects the amount of your deduction. These are the 2021 limits.
The amount you can contribute to a Roth IRA is limited by your MAGI as shown in Table 2-3.
If you file separately and did not live with your spouse at any time during the year, your IRA deduction is determined under the “Single” filing status.
TABLE 2-2 2021 IRA Deduction Limits
Your Filing Status | Your Modified AGI | Your Deduction |
|---|---|---|
Single or head of household | $66,000 or less | Up to your contribution limit |
More than $66,000 but less than $76,000 | Partial deduction | |
$76,000 or more | No deduction | |
Married filing jointly or qualifying widow(er) | $105,000 or less | Up to your contribution limit |
More than $105,000 but less than $125,000 | Partial deduction | |
$125,000 or more | No deduction |
Source: Internal Revenue Service
TABLE 2-3 Roth IRA Deduction Limits
Filing status | 2020 MAGI | 2021 MAGI | Contribution |
|---|---|---|---|
Single or head of household | <$124,000 | <$125,000 | Full contribution |
>$124,000 and <$139,000 | >$125,000 and <$140,000 | Partial contribution | |
>$139,000 | >$140,000 | No contribution | |
Married filing jointly or qualified widow(er) | <$196,000 | <$198,000 | Full contribution |
>$196,000 and <$206,000 | >$198,000 to <$208,000 | Partial contribution | |
>$206,000 | >$208,000 | No contribution | |
Married filing separately | <$10,000 | <$10,000 | Partial contribution |
>$10,000 | >$10,000 | No contribution |
Source: Internal Revenue Service
Paying attention if your spouse has a plan
The amount of your contributions to an IRA that you can deduct on your tax form may be limited if you or your spouse are covered by a retirement plan.
IRS standards for determining whether you or your spouse are covered by your employer’s retirement plan include the following:
Your employer has a recognized contribution plan, including a 401(k) plan, profit sharing, stock bonus, or money purchase pension plan. A money purchase pension plan is one that an employer contributes to for the employee’s benefit. The employee is barred from contributing but may be able to choose what the funds are invested in.
A defined benefit plan, which is, oddly enough, a pension plan with defined benefits, that you’re eligible to participate in within the tax year counts.
- Contributions or forfeitures (a fancy way of saying losses or withdrawals) were registered in your plan during the calendar year or plan year. The contributions may be to a SEP or SIMPLE IRA plan — I talk about those plans in Chapter 20.
One way to tell whether you’re covered in an employer-sponsored retirement plan is to check your W-2. If Box 13, the retirement plan box, is checked, you’re covered.
Table 2-4 shows how big a deduction you can take if you or your spouse has an employer-based plan. This table applies even if you or your spouse decides not to contribute to the plan that is available at work.
TABLE 2-4 Deduction Limits if Spouse Has an Employer-Sponsored Plan
Filing Status | 2020 MAGI | 2021 MAGI | Deduction |
|---|---|---|---|
Single or head of household | <$65,000 | <$66,000 | Full deduction |
>$65,000 and <$75,000 | >$66,000 and <$76,000 | Partial deduction | |
>$75,000 | >$76,000 | No deduction | |
Married filing jointly or qualified widow(er) | <$104,000 | <$105,000 | Full deduction |
>$104,000 and <$124,000 | >$105,000 and <$125,000 | Partial deduction | |
>$124,000 | >$125,000 | No deduction | |
Married filing separately | <$10,000 | <$ 10,000 | Partial deduction |
>$10,000 | >$10,000 | No deduction |
Source: Internal Revenue Service
Earning extra credit according to income
Congress approved an extra tax break to encourage low- and moderate-income earners to contribute to retirement accounts. This tax credit, called the Saver’s Tax Credit, is available to those who contribute to a 401(k), a traditional IRA, and/or a Roth IRA.
The saver’s credit is available if you meet all three conditions:
- You’re 18 or older.
- You’re not a full-time student.
- You’re not claimed as a dependent on someone else’s return.
You were a student if, during any part of five months of the tax year, you
- Were enrolled as a full-time student at a school.
- Took a full-time, on-farm training course given by a school or a state, county, or local government agency.
A school includes technical, trade, and mechanical schools. It doesn’t include on-the-job training courses, correspondence schools, or schools offering courses only through the internet.
The amount of the credit is 50 percent, 20 percent, or 10 percent of your contributions up to $2,000 — $4,000 if you’re married filing jointly. Eligibility and the amount of the credit is tied to your adjusted gross income. You can’t claim the credit if you make more than $33,000 or $66,000 if you’re married and file jointly. Table 2-5 shows the credit amount in 2021.
TABLE 2-5 2021 Saver’s Tax Credit Rates
Married Filing Jointly | Head of Household | Other Filers | Credit Rate |
|---|---|---|---|
Up to $39,500 | Up to $29,625 | Up to $19,750 | 50% |
$39,501–$42,000 | $29,626–$32,250 | $19,751–$21,500 | 20% |
$42,001–$66,000 | $32,251–$49,500 | $21,501–$33,000 | 10% |
More than $66,000 | More than $49,500 | More than $33,000 | 0% |
Source: Internal Revenue Service
The actual calculation of the tax credit has a few more rules that apply, and the amount of your tax credit may be further reduced by any plan withdrawals you (or your spouse) may receive (or have received in the past two years).
You must complete and file Form 8880 to get the credit. Request a copy from your employer or get one from www.irs.gov.
Taxing Income at Retirement
The amount of your taxable income at retirement is an important factor because if you’re like most retirees, you have much less taxable income when you don’t get a paycheck any longer. Social Security benefits are a large portion of most retirees’ income, and they will be for you, too, unless you have substantial assets or significant taxable income from other sources when you retire.
Fun fact: Social Security benefits weren’t taxable until 1984. Today, however, you can pay tax on up to 85 percent of your Social Security benefit — even though you pay federal income taxes on the amount you contribute to Social Security during all the years you work.
This comment used to get people attending my speaking engagements turning their heads, so let me explain: Both your federal income tax and Social Security taxes are computed as part of your gross income. This means you pay federal income tax on your Social Security taxes when you are working and paying them in. You also may have to pay taxes on 85 percent of your Social Security benefits after you retire.
Table 2-6 shows the portion of your Social Security benefit taxable in 2021.
TABLE 2-6 Tax Rates on Social Security Benefits in 2021
Filing Status | 0% for Income | 50% for Income | 85% for Income |
|---|---|---|---|
Single | Under $25,000 | $25,000 to $34,000 | Over $34,000 |
Married Filing Jointly | Under $32,000 | $32,000 to $44,000 | Over $44,000 |
Source: Internal Revenue Service
Taxes on your Social Security benefits come into play only if your combined income exceeds $25,000 for a single person and $34,000 for marrieds. If you’re a single taxpayer whose combined income exceeds $34,000 for 2021, 85 percent of your Social Security benefit is taxable. The 85 percent threshold for joint returns is $44,000.
Middle-income workers are the ones who need tax help the most: Lower-income earners receive a much larger percentage of their wages from Social Security, and top earners in large, publicly owned companies receive their big payoffs through employer-funded non-qualified retirement benefits and stock option plans.
An employee currently making $30,000 who retires at the normal Social Security retirement age will receive 45 percent to 50 percent of this amount in Social Security income. Financial pros say you need 70 percent of your pre-tax income as retirement income. So, this retiree needs only 20 percent to 25 percent of non–Social Security income to accomplish this — roughly $225,000 to $250,000 in retirement savings. This is equal to 7.5 to 8.3 times the worker’s $30,000 pre-retirement income.
An employee in the same situation with a $100,000 salary will receive 25 to 30 percent of this amount in Social Security income. This is a much smaller percentage of pay than the $30,000 wage earner even though both employees were paying 7.65 percent of their incomes in FICA tax prior to retirement (assuming they both work for an employer that also pays 7.65 percent). Making matters worse, a self-employed individual earning $100,000 must pay 15.3 percent in FICA taxes.
The $100,000 wage earner has been paying 3.3 times as much in FICA taxes but will receive only 1.7 times as much in benefits. This wage earner also will need sufficient assets to replace 40 to 45 percent of pre-retirement income to hit the 70 percent threshold. That will take $1,000,000 to $1,125,000 of assets — 10 to 11 times the worker’s pre-retirement income.
A self-employed person earning $100,000 will pay $15,300 in FICA taxes, or 6.7 times as much as the as an employee earning $30,000. Despite paying many times more in FICA taxes, the self-employed person receives only 1.7 times as much in Social Security benefits. This is one of the reasons why I am so passionate about helping solo entrepreneurs and small family businesses set up a plan that will give them the biggest tax break — because they deserve it. Oh, and by the way, up to 85 percent of your Social Security benefits may be taxable for self-employed and other workers.
Tax-qualified retirement plans have maximum benefit limits. Non-qualified plans have no maximum benefit limits, so the only restriction on how much benefit top cats can get is determined by the company’s board of directors.
Some more information about Social Security inequity:
- Paying taxes twice: Have you ever considered the fact that you’re taxed twice by the federal government on the Social Security taxes you pay? Everyone I tell this to gives me a strange look, but I’m only talking the truth. Your Social Security tax is determined using your gross income. So is your federal income tax; so your annual income is used to determine both taxes.
- Paying to be self-employed: The self-employed are required to pay 15.3 percent in FICA (Federal Insurance Contribution Act) taxes. A 22 percent federal income tax rate, plus a 2 percent state income tax, a 1 percent local wage tax, plus the 15.3% FICA tax results in a combined 40.3 percent rate.
Income and tax levels before and after retirement are fairly stark.
For example, assume you retired at the end of 2020 having earned $75,000 during 2020. Your Social Security benefit for 2021 should be approximately $25,000 if you qualify for full benefits. You need a $1,000,000 retirement nest egg to generate $40,000 per year of additional retirement income assuming a typical recommended 4 percent withdrawal rate (4 percent of $1,000,000). So, you start out 2021 with $10,000 less income than you had in 2020 but only the $40,000 withdrawn from your retirement account may be taxable.
All things considered, it’s improbable that tax rates will increase to a point where your tax rate on a substantially lower amount of taxable income will be higher than your current rate. This is why the highly promoted Roth tax advantage is a myth: Most retirees are in a lower tax bracket when they retire than when they were working.
You still have tax deductions after you retire, which can reduce your AGI significantly since you don’t have salary income. The standard deduction for a single taxpayer is $12,000.
Table 2-7 shows how 2020 and 2021 compare tax-wise for a single person who retired at the end of 2020.
TABLE 2-7 Comparing Taxable Income after Retirement
2020 Taxable Income | 2021 Taxable Income | ||
|---|---|---|---|
Salary | $75,000 | IRA withdrawal | $40,000 |
IRA deduction | + $7,000 | 85% of Social Security | + $21,250 |
Standard deduction | − $12,400 | Standard deduction | − $12,550 |
Taxable income | = $55,600 | Taxable income | = $48,700 |
Source: Internal Revenue Service
The amount of your taxable income is likely to be much less after you retire unless you have a larger retirement nest egg than $1,000,000 or significant taxable income from other sources.
Staying Alert to Changes in Tax Law
I remember well during the early days of the Roth IRA how retirement savers were encouraged by most financial pros to pay tax now rather than after they retire because Roth IRAs provided a big tax advantage. How well did this advice work out? Well, you win with the Roth option only if taxes are higher when you take out your money than when you put it in.
Table 2-8 shows the tax rates applicable to single and marrieds filing jointly during 1998 (the year after Roth IRAs became effective) and 2021.
TABLE 2-8 Comparison of 1998 and 2021 Tax Rates
Income 1998 Single | Income 1998 Married Filing Jointly | Tax Rate | Income 2021 Single | Income 2021 Married Filing Jointly | Tax Rate |
|---|---|---|---|---|---|
Up to $25,349 | Up to $42,349 | 15% | Up to $9,950 | Up to $19,900 | 10% |
$25,350 to $61,399 | $42,350 to $102,299 | 28% | $9,951 to $40,525 | $19,901 to $81,050 | 12% |
$61,400 to $128,099 | $102,300 to $155,949 | 31% | $40,526 to $86,375 | $81,051 to $172,750 | 22% |
$128,100 to $278,449 | $155,950 to $278,449 | 36% | $86,376 to $164,925 | $172,751 to $329,850 | 24% |
Over $278,449 | Over $278,449 | 39.6% | $164,926 to $209,425 | $329,851 to $418,850 | 32% |
$209,426 to $523,600 | $418,851 to $628,300 | 35% | |||
Over $523,600 | Over $628,300 | 37% |
Source: Internal Revenue Service
A single tax filer in 1998 would have been taxed at a 28 percent rate on taxable income above $25,350. The 2021 rate for taxable income above this level is 12 percent. The tax rate was 28 percent for a married couple filing jointly during 1998 on taxable income above $42,350 compared to 12 percent during 2021. So, it definitely did not benefit you to invest in a Roth IRA in 1998 and take money out in 2021. Check out Chapter 10 for more on Roth IRAs.
There’s no guarantee that retirement tax exemptions will be available in their current form in the future. Tax laws change all the time.