Today's Rude Opinion Poll: Which description best characterizes our elected representatives in Washington, regardless of party affiliation?
- They are hapless boobs, constantly passing laws that contradict each other.
- They are scheming miscreants, relentlessly seeking new ways to increase taxes and spend more of our money.
If you think the choices offered are unkind, please bear with me. We'll examine a little legislative history. You'll see how it will work to take today's employer contribution to your 401(k) plan and transfer most of it to the federal government during your retirement years.
When we are done, I believe you will agree that two choices are sufficient. Here's the story:
The 401(k) plans that now dominate retirement saving were launched in 1981. That's when the IRS set out the first formal rules describing the plans. Employers quickly started to add 401(k) plans to their employee benefits. The plans became very popular with employees, particularly when employers provided some matching funds. Plan balances are now one of the largest pools of untaxed assets in our economy.
In 1983 a presidential commission recommended that Social Security benefits be taxed. The recommendation became law in 1984. At the time, few retirees were affected because benefits were only to be taxed when other sources of income were quite high. With the initial income level set at $25,000 for a single return and $32,000 for a joint return, it was expected that only 1 percent of beneficiaries would pay any taxes on their benefits.
But there was a catch. The income levels weren't indexed to inflation. As inflation and economic growth increased the level of benefits for future retirees, more and more retirees would pay the tax.
For a couple, the taxation of benefits begins when your other sources of income plus one-half of your Social Security benefits exceeds $32,000. Today the average Social Security check is $1,048 a month or $12,576 a year. So an average two-earner couple may have benefits of $25,152. Subtract one-half of this amount from $32,000 and you have the amount of income they can have from other sources before benefits become taxable -- $19,424.
Once their other income exceeds $19,424 every additional dollar causes either 50 cents or 85 cents of benefits to be added to their taxable income.
Now let's fast forward about 17 years. According to the recently released Social Security trustees report, the average worker retiring in 2008 will receive benefits of $16,260 a year. By 2024 the average worker will receive benefits of $19,972, measured in today's dollars. Assuming a 3 percent inflation rate, this will mean cash benefits of $32,954.
Apply the formula for taxation of benefits and guess what happens? The average two earner couple that retires in 2024 will start paying taxes on their Social Security benefits with the first dollar they take from their 401(k) plan. Workers who are about 50 years old today can expect to pay income taxes on their Social Security benefits from day one. Workers who are younger than 50 can expect the same result even if their incomes are lower than average.
Now let's consider the composition, and disposition, of each dollar that goes into a typical 401(k) plan. In a typical plan, every dollar of employee contribution is matched by 50 cents of employer contribution. So each dollar going in is 67 cents of employee money and 33 cents of employer money.
Query: What is the composition of each dollar coming out?
Answer: There are four levels, depending on your tax status. Here they are:
Level One. At this level no Social Security benefits are taxed. Each dollar is likely to be 85 cents to the employee and 15 cents to the IRS. That's a good deal that's rapidly disappearing.
Level Two. At this level 50 cents of Social Security benefits are taxed for each dollar withdrawn. And the likely tax rate is 15 percent. So 77.5 cents of each dollar will go to the employee and 22.5 cents will go to the IRS. Basically, about two-thirds of the employer contribution goes straight to the IRS.
Level Three. Here, 85 cents of Social Security benefits are taxed for each dollar withdrawn and the basic tax rate is 15 percent. So 72.25 cents of each dollar goes to the employee and 27.75 cents of each dollar goes to the IRS. About 84 percent of the employer contribution goes to the IRS.
Level Four. Like level three, 85 cents of Social Security benefits are taxed for each dollar withdrawn, but the basic tax rate is 25 percent. As a consequence, 53.75 cents of each dollar goes to the employee and 46.25 cents goes to the IRS. In effect, the entire employer contribution (33 cents) plus 13.25 cents of the employee contribution has gone to the IRS.
How this tax mess will affect you depends on your income level and your age. If you are young, odds are your employer contribution will never buy you a slice of bread. It's really a fund for the IRS.
This takes us back to our Rude Poll. Are politicians hapless boobs or schemers?
ON THE WEB:
A history of 401(k) plans from the Investment Company Institute:
A brief history of the taxation of Social Security benefits from the Social Security Administration:
Tables of projected benefits, in current dollars, from the 2007 Social Security trustees report:
