You're 50 and married. You're doing so well Washington deems you to be "highly compensated," which they define as anyone earning at least $90,000 a year. You contribute the maximum allowed to your 401k plan because you love to cut your tax bill.
You long to retire to a land of beautiful golf courses and lower taxes.
Sorry, it won't happen.
You'll get the beautiful golf courses. But you won't get the lower tax rate. Indeed, a large portion of your income may be taxed at a stunning 46.25 percent--- higher if you live in a state with an income tax. So your 401k account will be worth less than you think. The after-tax value of a million dollar account would be only $537,500--- when you imagined it was worth $750,000 (after a 25 percent tax rate) or even $850,000 (after a 15 percent tax rate).
How does this happen? Follow me.
According to the Social Security Trustees report, a worker with "steady maximum earnings"--- someone who earns at least $90,000 in 2005--- will be eligible for $33,838 in benefits retiring at 65 in 2020. The non-working spouse would be eligible for half that bringing total benefits to $50,758.
Unfortunately, when half of your Social Security benefits and other income exceeds $32,000 your benefits become taxable. So the moment your other income exceeds $6,621, your Social Security benefits are taxed. The next $12,000 of income causes $6,000 of benefits to be taxed. It will take another $43,699 before you escape Social Security taxation.
In that last run of $43,699, for instance, each additional $1,000 will trigger the expected 15 or 25 percent rate. But it will also add $850 of Social Security benefits to be taxed. So you'll be paying a marginal tax rate of 27.75 or 46.25 percent. (If you are thinking, by the way, of calling your friendly Republican Congressman to get this changed, forget it. This tax trap is bi-partisan. It traces to 1983, David Stockman, and the Reagan administration. Bill Clinton only increased the basic tax rate. )
Can you escape?
Sorry, all you can do is avoid taking much money from your tax-deferred accounts. Indeed, it could be worse: if your spouse is also a maximum earner, half of your combined $67,518 in Social Security benefits, alone, will trigger taxation of the benefits. If you're under 50 it will be worse in any case. Why? That $32,000 threshold isn't indexed to inflation.
Can you protect yourself? Here are three ways.
First, limit your qualified plan contributions to the amount that captures your employer match. If the match is 50 percent of the first 6 percent of salary, stop at 6 percent.
Second, build assets you can spend without creating "taxable events." This means paying down a large home mortgage with the idea of downsizing later and liberating equity. It means contributing to a Roth-IRA if eligible. And you can simply pay taxes and invest in stocks, knowing dividends and capital gains are taxed at only 15 percent.
Third, build a fund that will allow you to take extra money in one year so you may avoid all, or most, of the taxation of Social Security benefits in the next year.