AssetBuilder Inc. Registered Investment Advisor - Simple Investing. Smart Future.

Your column on Monday gave me serious pause. On your scenario fast- forwarding 17 years, you outlined how taxation on Social Security benefits in the future could occur "with the first dollar they take from their 401k plan". I thought only CURRENT salary or wages counted when figuring taxes on SS benefits. Are you saying that 401k withdrawals count as salary would? If this is so, what about interest, dividends and company matches, not to mention after tax contributions which are in my account? Do they count as earnings also? Please clear this up for me. It may make a big difference for me whether I would work a small retirement job or not! 

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Every dollar that comes out of a 401(k) plan or IRA, with the exception of after-tax contributions, is included in the calculation of “modified adjusted gross income” for the taxation of Social Security benefits. That’s one of the reasons younger workers should prefer Roth IRAs over traditional plans.

Great article Scott. What hold true for 401k and IRAs does not hold true for Roth IRAs. I that correct?

 Funds from a Roth IRA are not considered taxable income as it stands today.

 

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That’s right. The Roth IRA is the one of the few escapes from taxation of Social Security benefits because that income is not included in the formula.

I read your article but didn't get the logic of the math.

If the top tax rate is 25% on all income, how does 46.25% (25%+ 25%(85%))  go to IRS. Wouldn't the most going to IRS be 25%, forgetting about exemptions, etc. How does adding the tax rate equate? Taxing the income doen't mean it goes to IRS.

The analysis uses marginal tax rates--- the rate you pay on each dollar of additional income. If you are in the 25 percent tax bracket and take an additional $1,000 from your IRA rollover account, you will have to pay $250 in federal income taxes on that withdrawal. That $1,000, however, can cause $850 of Social Security benefits to be added to your taxable income causing your tax bill to increase by a further $212.50. That brings the total to $462.50 or 46.25 percent of the $1,000 from your IRA. Remember, before this the SS benefits were not taxed.

 
We write our tax checks to the IRS. The money then goes to the U.S. Treasury which pays it out to meet government expenses.

I read your column almost every day, and I usually find it informative and useful.  But today's column greatly exaggerates the fraction of income a person pays in taxes by omitting the Social Security income from the denominator of the fraction.  This is grossly misleading, and you should print a retraction/correction immediately.  
 
In your last example, the amount of each dollar of total income (not merely the income from the 401(k)) going to the IRS is 23.93 cents, not 46.25 cents, assuming an income of $50,000 and a Social Security of $19,972.
 
It should be obvious that the fraction of taxes on total income will not exceed 25 cents on the dollar.  Not even the IRS can do that.
 
Sincerely,
 
Don

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Don,

I wish your interpretation was correct but it is not. The analysis is of  marginal tax rates--- the tax that falls on the next dollar of income. Initially, every dollar of Social Security benefits is tax-free. It only becomes taxable when we have other sources of income. When our other sources of income exceed the threshold amount, each additional dollar of, say, IRA withdrawal will (1) be taxed in its own right and (2) cause 50 cents to 85 cents of Social Security benefits to be added to taxable income. In effect, each dollar of additional income is taxed as $1.50 or $1.85, hence the higher effective marginal tax rate.

Many people have difficulty getting their heads around this idea. The best way to illustrate it is to use some tax return software and experiment with the total tax bill and how it is affected by an additional $1,000 of income. The tax bill rises exactly as I have said it does.

I thought that once you reach full retirement age you could earn as much as you want with no reduction in social security benefits.

      Virtually all income counts for the Social Security benefit taxation calculation. ALL money in qualified plans, regardless of source, is regarded as ordinary income and is becomes taxable when it is withdrawn. In addition, taxable interest income is included as are dividends, capital gains, pensions, and interest income from tax-free municipal bonds. After-tax contributions are not counted. Withdrawals from Roth IRA accounts are not included.

    Here is a link to more information:

http://www.fairmark.com/rothira/socsec.htm

Scott
 

 

 

I'm confused.  Social security benefits are not part of your 401(k), so how
can taxes on social security benefits be assigned to the company-match
portion of 401(k) deductions?  Shouldn't the portion of social security benefits that you keep also be considered?

Thanks,

Heath

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Heath,

Social Security benefits aren't part of your 401(k). Nor are they part of your pension, your dividend income, your interest income, or your capital gains income. But our tax code was rewritten in 1983 and again in
1993 to start including Social Security benefits into your taxable income as your total income level rose. Because the threshold amounts are not indexed to taxation the number of retirees who are affected rises each year.

The formula is complicated but it amounts to a kind of means testing for Social Security, taxing the benefits of those with more income from other sources. When you calculate the effective tax rate on a marginal
basis--- the tax paid on the next dollar of income--- the tax rate can be as high as 46.25 percent.

Scott

I think it would be worthwhile to point out that income after the age of 70 does not reduce Social Security benefits ( that would certainly change your column). Of course that's only useful if you have enough resources to survive until 70 to begin collecting SS. 

P Durda

 

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The taxation of Social Security benefits and the reduction of Social Security benefits for working are two different things. Those who take benefits before full retirement age (65 to 67, depending on birth year) are subject to a reduction in benefits if their earned income exceed certain amounts--- $12,960 in 2007. ALL Social Security recipients are subject to the taxation of benefits if their income from virtually all sources exceeds certain amounts.

I read your article in the May 29 Herald with great interest. How typical of the IRS to try to get our money! My question to you is: I will be 65 in October and do not plan on retiring for at least 5 more years God willing. I have a terrific job where my company not only matches my contribution, but they put in 16 to 20% (over the next 4 years) of my salary into my 401K. I will be fully vested for these funds after 5 years on the job (I started 8 mos. ago) which is the reason I do not want to retire. I didn't understand your four levels, where the IRS will take more money each year. At my age, will this problem affect me or just my 3 children who are in their 30's now? In five years from now, will I still get all the money I have in my 401K (less taxes of course)?

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