Some readers, who are old enough to remember defined pension plans weren’t just for unionized workers, may still think they are better off with IRAs and 401Ks, originally sold as tax-free until you retire.
Advice from employers promised the new plan was better than a pension. You could put away as much as the equivalent today of $6,000 a year – pay no income tax – if you could afford it. When you were 59 !/2, you could start withdrawals and just pay income tax on the money withdrawn at lower income tax rates if you weren’t working.
That was the sales pitch, but here’s what may really happen to investors.
The average retired couple on Social Security today earns about $36,000 total a year. (Some $3,600 is deducted for Medicare premiums – netting them $32,400.)
Under laws passed in the 80s, half that $36,000 in benefits must be reported as earnings for income tax purposes, using up $18,000.of their standard senior deduction ($27,400).
That leaves only $9,400 for other earnings before they begin paying into the Internal Revenue Service (IRS).
To compound matters, in the year after they are 72, they must withdraw a percentage of their savings from IRAs or 401Ks. The IRS calls this the Required Minimum Distribution, a percentage of all tax-deferred assets..
After retirement all 401k or IRA withdrawals, including the RMD at 73, are taxable at current income tax rates, plus half of Social Security benefits.
If a couple withdraws $25,000 a year from their IRA for expenses, that amount is added to the $18,000 Social Security benefit, Total taxable income becomes $43,000. That’s $15,600 more than their $27,400 standard deduction for married, filing jointly.
But there is more bad news. Because the couple reported $43,000, every dollar above $32,000 is subject to additional income tax on Social Security. Half of everything exceeding $32,000, some $11,000, is halved to add $5,500 to the original $15,600 taxable income. The new total: $21,100.
The $32,000 limit was passed in the 1980s so very rich folks would pay taxes on at least part of their Social Security benefits, but that amount has not changed since, and $32,000 is no longer rich.
Income tax bill for $21,100 amounts to: 10% of first $9,875 ($988), plus 12% of remaining $11,225 ($1,347) or a total of $2,335.
Before the “reforms” under President Ronald Reagan in the 80s, this couple would pay $513 with the same earnings total.
What happens if there is no IRA or 401K and the couple withdraws $64,000 (not just $25,000) in long-term (held more than a year) Capital Gains – stock appreciation, real estate investments, many mutual funds etc.
Answer: no income tax under current law. If those same capital gains were earned inside an IRA/401K, all revenue would be taxable at regular rates.
Capital Gains allows anyone to withdraw large sums annually (up to $80,000 a year) tax exempt, vs. 10% to 37% for IRA/401K distributions.
The quandary is whether is pay taxes after you retire (401K/IRA), or when you first invest the money.
Example of IRA/401K Taxes
- $57,000 in wages.
- 10% paid into IRA/401K = $5,700 annually.
- Social Security benefit for couple of $32,000, and withdrawal of $25,000.
- After retirement Income Tax bill of $2,335 X 20 years = $46,700.
- Income Tax must also be paid by survivors (added to their personal annual earnings) on all remaining IRA/401Ks at regular rates – as high as 37%. These deferred funds are excluded from regular inheritance tax thresholds, and must be paid in full.
Example of Capital Gains Taxes
- $57,000 in wages.
- 10% invested into future Capital Gains (Mutual Funds, Real Estate) = $5,700 annually.
- Income tax paid on investments = $5,700 % X 12% X 40 years, or total paid of$27,360.
- Income tax after retirement is none. No tax for survivors unless total estate value exceeds $23.4 million.
My conclusion is what you save in current taxes with an IRA or 401K may substantially exceed income tax paid in retirement, especially with half of Social Security subject to tax.
Because of low current income taxes for the middle class, sacrificing some tax savings now could be a gigantic savings for your survivors, who would otherwise pay up to a third of their inheritance in income taxes, even with a special five-year survivor’s distribution.
The addition of an employer-paid 401K benefit improves the tax picture. This is usually up to 5%, and you must match by the same amount. Regardless of tax consequences, this is a win-win, but once you go over the matching requirement, your retirement funds might be happier in vehicles focused on capital gains.
Those in a very high income tax bracket – probably more than likely would greatly benefit from either a 401K or traditional IRA. Not a surprise that what we were sold instead of a pension, helps the rich more than us. A Roth IRA is an alternative, where you invest with after-tax money, but such plans can restrict withdrawals before 59 1/2, and where you can invest your money.
Tax filing deadline is next Tuesday for average Americans.