Tag: income tax

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Income Tax Planning

The 2013 Tax Law Schizophrenic Definition of Income – Part 1 of 2

QUOTED AND LINKED IN JANUARY 11, 2013 WALL STREET JOURNAL

And you thought that the tax law was already too complex. As a result of President Obama’s signing on January 2nd of the American Taxpayer Relief Act of 2012 following changes legislated by the 2010 Health Care Reform Act effective beginning in 2013, there are now five different definitions of income affecting seven different tax areas.

With a schizophrenic name (“Taxpayer Relief Act”), this comes as no surprise.

Although the most publicized affected income level is individuals with taxable income exceeding $400,000 for single tax filers and $450,000 for married filing joint tax filers, everyone with employment or self-employment income of any amount with limited exceptions will pay more tax in 2013 than they did in 2012, all else being equal.

Exhibit 1 summarizes 2013 individual federal income-based tax law changes, comparing each one with the law in effect in 2012. The five different definitions of income are as follows, with dollars amounts depending upon single vs. married filing joint tax status with the exception of #1 which applies to everyone with earned income with limited exceptions:

  1. Earned income of between $0 and $113,700
  2. Earned income and modified adjusted gross income exceeding $200,000 or $250,000
  3. Modified adjusted gross income exceeding $200,000 or $250,000
  4. Adjusted gross income exceeding $250,000 or $300,000
  5. Taxable income exceeding $400,000 or $450,000

The first three definitions of income will be discussed in the remainder of this post, with the last two deferred to next week’s post.

Earned Income Between $0 and $113,700

The employee Social Security tax rate which was reduced from 6.2% to 4.2% for 2011 and 2012 is back to 6.2% beginning in 2013. In addition, the Social Security wage base, which was $106,800 in 2010 and 2011 and $110,100 in 2012 is $113,700 in 2013. This translates to a Social Security tax increase of $2,425.20 in 2013 vs. 2012 for individuals with Social Security wages of at least $113,700, with the tax going from $4,624.20 (110,100 x 4.2%) in 2012 to $7,049.40 ($113,700 x 6.2%) in 2013.

Earned Income and Modified Adjusted Gross Income Exceeding $200,000 or $250,000

In recent years, everyone with earned income has been subject to Medicare tax at a rate of 1.45% on all earned income with limited exceptions. Beginning in 2013, the rate is increased by 0.9% to 2.35% on earned income exceeding $200,000 if single or $250,000 if married filing joint if modified adjusted gross income (“MAGI”) also exceeds the specified threshold amounts. MAGI is adjusted gross income (“AGI”) with certain adjustments, the details of which are beyond the scope of this post.

Modified Adjusted Gross Income Exceeding $200,000 or $250,000

The first two definitions of income are dependent upon the presence of earned income. It doesn’t matter if you have any earned income for purposes of meeting the next three definitions of income. If your MAGI exceeds $200,000 if single or $250,000 if married filing joint, and you have investment income, you will be subject to the new Medicare investment income tax. The tax is assessed at a rate of 3.8% on the lesser of net investment income or MAGI in excess of the specified threshold amounts. Net investment income includes taxable interest, dividends, and capital gains.

If you have income of at least $100,000 and you haven’t retired TurboTax and rehired your CPA yet, I’ll guarantee you will do so after reading part 2 of this post.

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Income Tax Planning Social Security

Say Goodbye to Up to 30% of Your Social Security Benefits – Part 2 of 2

Retirement Income Center

Taxation of Social Security benefits has been a thorn in Congress’ side ever since it came into being in 1984. As aptly stated by one of Retirement Income Visions’™ readers after reading Part 1, it’s a tax on a tax. After having one’s earnings, up to a maximum limit, reduced by a payroll tax of 6.2% for all of one’s working life, it’s difficult for Social Security recipients to stomach the fact that their benefits may be reduced by yet another tax — income tax.

Per last week’s post, since 1984, up to 50% of Social Security benefits became subject to income tax, with this percentage increasing to 85% beginning in 1994. Although the “combined income” (50% of Social Security benefits plus adjusted gross income increased by tax-exempt income) thresholds are relatively low for having up to 85% of one’s benefits subject to tax (i.e., greater than $34,000 if you use single, head of household, or married filing separate filing status and over $44,000 for married filing joint status), and, furthermore, haven’t ever been increased for inflation, you will never forfeit 85% of your benefits.

As explained last week, the maximum percentage of your Social Security benefits that you will lose to federal income tax is 29.75%. Furthermore, this will only occur if your “combined income” is several hundred thousand dollars. Even if up to 85% of your Social Security benefits are subject to taxation, it’s possible that you may only lose 5% of your benefits to income tax if your combined income is low.

To demonstrate this and to help you better understand the taxation of Social Security benefits, I have prepared Exhibit 1. This exhibit includes nine different scenarios for nine hypothetical people who receive Social Security income of $20,000, other income ranging from $15,000 to $270,000 depending upon the scenario, uses single filing status, and claims one exemption and the standard deduction.

“Combined income” is calculated in each scenario, which is equal to 50% of Social Security benefits, or $10,000 (50% x $20,000), plus adjusted gross income increased by tax-exempt income. Since single filing status is being used, the maximum taxable Social Security benefits percentage will be as follows:

Combined Income

Maximum Taxable Percentage
Less Than $25,000

0%
$25,000 – $34,000

50%
$34,001+

85%

It’s important to note that the maximum taxable percentages per the above table are exactly that – maximum percentages. As examples of this:

  1. Even though the maximum taxable Social Security benefits percentage is 50% in scenario #2, only $3,000, or 15% ($3,000 divided by $20,000), is taxable.
  2. Even though combined income exceeds $34,000 beginning with Scenario #3, it isn’t until Scenario #5 when combined income is equal to $48,706, that 85% of Social Security benefits of $20,000, or $17,000, is taxable.

After calculating the amount of combined income and taxable Social Security benefits, each scenario shows the amount of federal income tax including and excluding the taxable Social Security benefits. The difference between these two amounts is the tax that is attributable to the taxable Social Security benefits. The amount of tax that is attributable to the taxable Social Security benefits is then subtracted from the Social Security benefits of $20,000 to arrive at “Social Security Benefits Net of Federal Income Tax,” or net Social Security benefits. This is the amount of Social Security that the hypothetical person in each scenario gets to keep after paying the income tax that is attributable to the taxable portion of his/her benefits.

As a final step, the “Social Security Benefits Net of Federal Income Tax” is divided by the Social Security benefits of $20,000 in each scenario to determine the percentage of Social Security benefits that is retained after paying the tax that is attributable to the taxable portion of benefits. Based on the maximum taxable Social Security benefits percentage, the percentage of benefits retained is greater than what one might envision before running the calculations. As examples of this:

  1. 97.8% of benefits are retained in scenario #2 even though the maximum taxable Social Security benefits percentage is 50%.
  2. 94.7% and 90.3% of benefits is retained in scenario #3 and #4, respectively, even though the maximum taxable Social Security benefits percentage is 85%.
  3. Approximately 75% to 80% of benefits are retained in scenarios #5 through #8 even though the maximum taxable Social Security benefits percentage is 85%.

It isn’t until we get to scenario #9 where we get close to the maximum percentage of Social Security benefits that you can lose to income tax, i.e., 29.75%. It is in this scenario with combined income of $280,000 that 28% of Social Security benefits are lost to federal income tax and 72% is retained.

While it seems unfair to most Social Security recipients that their retirement benefits are subject to taxation, hopefully it’s somewhat comforting to know that the percentage of benefits lost to income taxation in most cases isn’t as high as one might have thought before reading this post.

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Income Tax Planning Social Security

Say Goodbye to Up to 30% of Your Social Security Benefits – Part 1 of 2

Retirement Income Center

Retirement Income Visions™ began a series of posts on the topic of Social Security on September 27th, focusing on various little-known strategies for maximizing Social Security benefits. In addition to the strategies not receiving a lot of publicity, when they are discussed, income taxation is often overlooked. Given the fact that a large portion of Social Security benefits can be subject to income tax, maximization of after-tax Social Security benefits should be your goal with each strategy.

Prior to 1984, Social Security benefits were nontaxable. Beginning in 1984, up to 50% of Social Security benefits became subject to taxation. The percentage was increased from 50% to up to 85% beginning in 1994. Since 1994, up to 85% of Social Security benefits are taxable, depending upon the total of two individual calculations: (1) 50% of Social Security benefits plus (2) adjusted gross income increased by tax-exempt income. While tax-exempt income generally isn’t taxable, it comes into play when calculating the taxable amount of one’s Social Security benefits. Whenever the total of these two amounts, otherwise referred to as “combined income,” exceeds a specified threshold, a portion of Social Security benefits is taxable.

The amount of the threshold is dependent upon your tax filing status. If your status is single, head of household, or married filing separate, the threshold is $25,000. If, on the other hand, your status is married filing joint, then your threshold is $32,000. The greater the excess of “combined income” over the specified threshold, the greater the amount of taxable Social Security benefits.

The $25,000 and $32,000 thresholds are the floor amounts for calculating taxable Social Security benefits. Up to 50% of Social Security benefits are taxable if your combined income is between $25,000 and $34,000 if you use single, head of household, or married filing separate filing status. The combined income level for married filing joint status for taxation of up to 50% of Social Security benefits is between $32,000 and $44,000. Once the upper limits of these respective thresholds are exceeded, up to 85% of Social Security benefits are taxable.

So, if up to 85% of Social Security benefits are taxable, why is the title of this post, Say Goodbye to Up to 30% of Your Social Security Benefits? As with taxation of all income, the amount of income tax that you pay is dependent upon the amount of your taxable income. Taxable income is calculated by subtracting itemized deductions or the standard deduction and personal exemptions from adjusted gross income. Once you determine your taxable income, income tax rates are applied to specified ranges of taxable income that are dependent upon your tax filing status. Federal income tax rates currently range from a low of 15% to a high of 35%.

Assuming that your situation is such that 85% of your Social Security benefits are taxable and assuming that you’re in the top tax bracket of 35%, then you will lose 29.75% (85% x 35%), or approximately 30%, of your Social Security benefits to federal income tax. Conversely, you will retain 70.25% (100% – 29.75%), or approximately 70%, of your benefits after paying the income tax attributable to them.

In an effort to help you better understand taxation of Social Security benefits, next week’s post will include calculations of taxable Social Security benefits, federal income tax attributable to taxable benefits, and Social Security benefits net of federal income tax for various income levels. All of you analyticals will love this one!

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Social Security

Do Your Homework Before Flipping the Social Security Switch – Part 4 of 5

Retirement Income Center

Affect on Amount of Spouse’s Social Security Benefit

In Parts 2 and 3 of this series, we looked at two factors that can result in an increased reduction of reduced Social Security benefits resulting from commencement of receipt of benefits at age 62 instead of waiting until full retirement age (“FRA”): (1) receipt of employment income between age 62 and FRA in excess of Social Security Administration’s specified limit, and (2) income tax attributable to Social Security benefits. Part 3 included an example whereby an individual who is eligible to receive annual benefits of $24,000 at FRA 66 instead receives benefits of approximately $13,000, or 54%. The reduction of approximately $11,000, or 46%, is attributable to electing to begin benefits at 62 and being subject to these two factors.

In addition to reducing your benefit amount if you begin receipt at age 62, it’s important to keep in mind that you will also reduce your spouse’s benefit if he/she claims a benefit based on your earnings record. As a spouse, you can either claim a benefit based on your earnings record, or, alternatively, you can collect a spousal benefit equal to 50% of your spouse’s Social Security benefit. You cannot collect a spousal benefit until your spouse files for his/her own benefit. Furthermore, you must be age 62 to qualify to receive a spousal benefit. As a widow or widower, however, you can start receiving Social Security survivors benefits at age 60.

Continuing with our example and assuming there is no work-related reduction of benefits, if you wait until age 67 to begin receiving your benefit of $2,000 per month, your spouse is eligible to receive 50% of $2,000, or $1,000 per month, as a spousal benefit. This amount will be received provided your spouse waits until his/her FRA. As stated above, a spousal benefit can be received as early as age 62, however, it will be reduced for each month before the spouse’s FRA that he/she begins collecting benefits. If receipt of spousal benefits begins at age 62, the benefit amount could be as little as 32.5%, instead of 50%, of the spouse’s benefit.

Let’s assume that you begin receiving your benefit at age 62 when you’re eligible to receive $1,500 per month vs. $2,000 per month if you wait until age 67 to being collecting your benefits. Let’s further assume that your spouse receives a spousal benefit. He/she will receive 50% of $1,500, or $750, assuming that he/she waits until FRA to begin receiving his/her spousal benefit. This translates to a benefit reduction totaling $750 ($500 for you plus $250 for your spouse).

Suppose instead that you begin receiving your monthly benefit at age 62 and your spouse also begins receiving his/her spousal benefit at age 62. You will receive $1,500 per month and your spouse will receive 32.5% of your benefit, or $488, instead of $750 if he/she waited until FRA. This results in a benefit reduction totaling $1,012 ($500 for you and $512 for your spouse). Instead of receiving monthly benefits totaling $3,000 ($2,000 for you and $1,000 for your spouse) had you and your spouse waited until your respective FRA’s to begin collecting your benefits, your total benefits are instead reduced by $1,012, or 33.7%, to $1,988 ($1,500 for your and $488 for your spouse) as a result of both of you electing to receive your benefits at age 62.

As if the Social Security benefit commencement decision wasn’t complicated enough, factor in the affect on your spouse’s benefit, and your head is sure to spin. Part 5 will discuss how one’s health will affect the decision regarding the timing of commencement of Social Security benefits.

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Social Security

Do Your Homework Before Flipping the Social Security Switch – Part 1 of 5

Retirement Income Center

“The trouble with resisting temptation is it may never come your way again.” (Unknown) Truer words were perhaps never spoken when it comes to deciding when to begin receiving Social Security benefits. The good news is – you can begin receiving your lifetime monthly benefit at age 62. The bad news is – you can begin receiving your lifetime monthly benefit at age 62.

As explained in last week’s post, Plan for the Frays in Your Social Security Blanket – Part 2 of 2, the ability to collect Social Security retirement benefits beginning at age 62 vs. the historical benefit commencement age of 65 has been available for almost 50 years – since 1961. The price for making this election from 1961 until 1999 was a 20% reduction in benefits otherwise payable at full retirement age (“FRA”). With the increase in FRA from age 65 to as long as age 67 beginning in 2000, the 20% reduction increased by 0.8% to 10%, with the amount of the percentage varying depending upon one’s year of birth.

At one end of the spectrum, anyone born in 1938 who elects to begin receiving Social Security benefits at age 62 will have a 20.83% reduction, or will collect 79.17% of benefits otherwise payable beginning at FRA 65 and 2 months. At the other extreme, those individuals born in 1960 or later who elect to receive Social Security benefits beginning at age 62 will experience a 30% reduction, collecting 70% of benefits otherwise payable beginning at FRA 67.

What is the optimal age to begin collecting Social Security benefits? There is no universal answer to this question. It instead needs to be analyzed for each situation, incorporating a number of factors that will be discussed in parts 2 through 5 of this blog. While lack of other sources of retirement income will generally dictate commencement of benefits sooner than later, assuming this isn’t your situation, you need to be aware of the ramifications of flipping the Social Security switch at age 62 vs. some later age.

Assuming that your financial situation is such that you’re not dependent upon Social Security for your financial survival at age 62, the following four factors should be considered individually and collectively when making the decision regarding when to begin receiving benefits:

  1. Potential employment income between age 62 and FRA
  2. Income tax attributable to Social Security benefits
  3. Affect on amount of spouse’s Social Security benefit
  4. Health

Each of the foregoing factors will be separately discussed in parts 2 through 5 of this series using examples to help you understand the importance of each of them with respect to your decision regarding the timing of the commencement of your Social Security retirement benefit.

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Retirement Asset Planning Retirement Income Planning

Retirement Income Planning – The End Game

Retirement Income Center

If you’re a subscriber to Retirement Income Visions™, you may have noticed that, although there have been nine posts prior to this one, none of them has stayed true to the theme of this blog, i.e., Innovative strategies for creating and optimizing retirement income. This post will be no exception. As the saying goes, there’s a method to my madness. In order to understand and appreciate the strategies and apply them to your situation, it’s important to understand the origin of retirement income planning, including the limitations of the retirement asset planning approach.

As explained in The Retirement Planning Paradigm Shift – Part 2, retirement planning is undergoing a paradigm shift. Instead of relying on retirement asset planning as a solution for both the accumulation and withdrawal phases of retirement, people are beginning to recognize, understand, and appreciate the need for, and value of, employing retirement income planning strategies during the withdrawal phase. No doubt about it, per Retirement Asset Planning – The Foundation, retirement asset planning is the way to go in the accumulation stage to build a solid foundation for a successful retirement plan. However, as discussed in The Retirement Planning Shift – Part 2, as a result of the uncertainty of traditional retirement asset planning as a solution for providing a predictable income stream to match one’s financial needs in retirement, retirement income planning was born.

Is Your Retirement Plan At Risk? introduced six risks common to all retirement plans: inflation, investment, income tax, longevity, health, and Social Security benefits reduction.

Beginning with Retirement Asset Planning – The Foundation, the inadequacy of retirement asset planning during the “spend-down” phase was discussed. This begins with the process itself. Unlike most types of financial planning where you get to see the results of your plan after reaching a specified target date, this is not the case with retirement asset planning since the timeframe is undefined.

Withdrawal Drag – The Silent Killer contrasted the beauty of compound rates of return during the accumulation stage with the erosion of portfolio income and the associated benefit of compounding, otherwise known as “withdrawal drag,” in the withdrawal stage of retirement. There is yet another phenomenon that can wreak havoc on your portfolio if you only rely on a retirement asset planning strategy during your retirement years. The Sequence of Returns – The Roulette Wheel of Retirement exposed this investment phenomenon and provided an example of how “luck of the rate-of-return draw” can prematurely devastate a conservative, well-diversified portfolio.

As if all of these variables and financial phenomenon were not a wake-up call to your planning, we mustn’t forget about the “safe withdrawal rate.” Safe Withdrawal Rate – A Nice Rule of Thumb demonstrated how the widely-accepted 4% “safe” withdrawal rate doesn’t necessarily guarantee that you won’t outlive your investment portfolio. Furthermore, the withdrawal amount that is calculated using this methodology typically won’t match your retirement needs.

All of the foregoing financial risks and phenomenon contribute to the inherent uncertainty associated with the retirement asset planning process during the withdrawal phase of retirement. As pointed out in Retirement Asset Planning – The Foundation, even if you’ve done an excellent job of accumulating what appear to be sufficient assets for retirement, you generally won’t know if this is true for many years

Retirement income planning is truly the end game in financial planning. Assuming that your goal is to generate a predictable income stream to match your financial needs in retirement while minimizing your exposure to withdrawal drag, the sequence of returns, and the various risks common to all retirement plans, it generally makes sense for you to begin employing retirement income planning strategies for a portion of your assets ten years before you plan to retire. The amount of assets and the exact timing of implementation are dependent upon your particular retirement and other financial goals as well as your current and projected financial situation.

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Financial Planning Retirement Asset Planning Retirement Income Planning

Is Your Retirement Plan At Risk?

Retirement Income Center

Before I write about the specific risks associated with retirement asset planning and the strategies that retirement income planners use to address, and, in many cases, mitigate, these risks, let’s take a look at risks that are common to all retirement planning. While many of these are uncertain and/or uncontrollable, each of them needs to be addressed in a retirement plan.

The risks that will be discussed are as follows, with the first three common to all types of financial planning, and each one intended to be a brief introduction vs. a comprehensive discussion:

  1. Inflation
  2. Investment
  3. Income tax
  4. Longevity
  5. Health
  6. Social Security benefits reduction

Inflation

Although it is unpredictable as to amount and fluctuation as it pertains to individual and overall variable expenses, a key risk that must be considered in the design and funding stages of all retirement plans is inflation. Unlike most types of financial planning where it is a factor only in the accumulation phase, inflation is equally, if not more important, during the withdrawal stage of retirement planning. The longer the time period, the more magnified are the differences between projected vs. actual inflation rates insofar as their potential influence on the ultimate success of a particular retirement plan.

Investment

Unless you are living solely off of Social Security or some other government benefit program, you are directly or indirectly exposed to investment risk. Even if you are receiving a fixed monthly benefit from a former employer, although it isn’t likely, your benefit could potentially be reduced depending upon the investment performance of your former employer’s retirement plan assets and underlying plan guarantees. Whenever possible, investment risk should be maintained at a level in your portfolio that is projected to sustain your assets over your lifetime while achieving your retirement planning goals, assuming that your goals are realistic.

Income Tax

Even if income tax rates don’t change significantly as has been the case in recent years, income tax can consume a sizeable portion of one’s income without proper planning. With the exception of seven states (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) that have no personal income tax and two states (New Hampshire and Tennessee) that tax only interest and dividend income), the rest of us need to be concerned about, and plan for, state, as well as, federal income tax. In addition, if you have a sizeable income, it is likely that income tax legislation will be enacted that will adversely affect your retirement plan on at least one occasion during your retirement years.

Longevity

Unlike other types of financial planning, the time period of retirement planning is uncertain. Although life expectancies are often used as a guide to project the duration of a retirement plan, no one knows how long someone will live. The risk associated with the possibility of outliving one’s assets is referred to as longevity risk. In addition, life expectancies, themselves, are changing from time to time. The August 19, 2009 edition of National Vital Statistic Reports http://bit.ly/pAgRk announced a new high of nearly 78 years for Americans. Planning is further complicated for married individuals since you are planning for multiple lives.

Health

An extremely important risk that is sometimes overlooked or not given enough consideration in the design of retirement plans is health. Under-, or uninsured, long-term care events as well as premature death in the case of a married couple, can deal a devastating blow to an otherwise well-designed retirement plan. It is not unusual for a prolonged long-term care situation, such as Alzheimer’s, if not properly planned for, to consume all of one’s retirement capital and other assets. Inadequate life insurance to cover the needs of a surviving spouse can result in dramatic lifestyle changes upon the first spouse’s death.

Social Security Benefits Reduction

Once considered to be unshakable, the security of the Social Security system, including the potential amount of one’s benefits, is questionable. In addition, it was announced in May that for the first time in more than three decades Social Security recipients will not receive a cost of living adjustment, or COLA, increase in their benefits next year. While beneficiaries have received an automatic increase every year since 1975, including an increase of 5.8% in 2009 and a 14.3% increase in 1980, this will not be the case in 2010.

Each of the foregoing six risks needs to be considered, and appropriate strategies developed, in the design and implementation of every retirement plan to improve the chances of success of the plan.