To avoid a tax trap, you must first understand it.

"My co-workers and I," S.M. writes, "are all around 30 years old and perplexed as to what counts as income when we retire. We all have Roth IRAs. Some of us also have VUL (variable universal life) in our investment portfolios. We also have 401(k) accounts and taxable mutual funds.

"The question we have is: Can the government tax us twice on an investment? For example, the advantage of a Roth IRA, as we understand it, is that the money is taxed when you initially invest it. But then the gains are tax-free. When we withdraw money from our Roth IRA at retirement, does the money count against the $32,000 threshold (for the taxation of Social Security benefits)?"

The simple answer: "No."

One of the advantages of the Roth IRA is that it is one of the few investment vehicles that deliver non-taxable retirement income. Because of this, I believe young workers should build assets in Roth IRA accounts.

If all this seems like gibberish to you, don't feel badly. Our friends in Congress love gibberish. They laid a delayed action tax trap more than 20 years ago, written entirely in gibberish.   That was when they initiated the taxation of Social Security benefits. They did this by creating a complex formula for "provisional income" that caused some of your Social Security benefits to be taxable when the combination of one half of the benefits plus your other income exceeded $25,000 for a single person, $32,000 for a joint return.

Not satisfied with the work of Republicans, the Democrats later added another level of taxation. Once your provisional income on a joint return exceeded $44,000 (or $34,000 on a single return) every additional dollar of other income caused 85 cents of Social Security benefits to become taxable.

Back in the mid-1980's it wasn't much of a tax. Few retirees had provisional incomes that reached the threshold figures. Unlike virtually everything else in the entire U.S. tax code except the dreaded Alternative Minimum Tax, however, the Social Security taxation thresholds are fixed.

They are not indexed to inflation. They are the same today as when they were passed into law.   As Social Security benefits increase and the $25,000 or $32,000 thresholds remain fixed, more and more retirees are encountering the tax.

Suppose, for instance, a two income couple retires and both are entitled to Social Security benefits of $1,200 a month. Their Social Security income is $28,800 a year. Half of that amount is $14,400. Subtract $14,400 from the $32,000 threshold and their other income can be no more than $17,600. Over that amount and Social Security benefits start being added to taxable income. In effect, each additional $1,000 of "other" income adds $500 to taxable income. As a consequence, a $1,000 withdrawal from an IRA that you expected to be taxed at 15 percent will trigger the taxation of $1,500. Your tax bill on that $1,000 of new income will increase from $150 to $225.

A Quick Test of Social Security Benefit Taxation
To determine if your Social Security benefits will be subject to taxation subtract  ½ of your benefits from the appropriate marital status and you'll know how much "other income" you can have before your Social Security benefits start becoming taxable income.
Single Taxpayer Married Couple(Joint Return)
$25,000 $32,000
Less  ½ Social Security benefits Less  ½ Social Security benefits
Equals Maximum "Other income" Equals Maximum "Other Income
Source: I.R.S. publication 915

Increase your "other" income to the second stage and each additional $1,000 withdrawal will cause $850 of Social Security benefits to become taxable. If this happens an additional $1,000 of income will cause $1,850 of income to be taxed. If the income is in the 25 percent tax bracket you'll pay $475 in additional taxes instead of the expected $250. That's a heavy bite on $1,000 of additional income.

How do you avoid this?

It isn't easy.

Withdrawals from 401(k), 403(b), and 457 accounts count as other income. So do traditional IRA withdrawals. So do dividends, interest, and capital gains. So does interest on supposedly tax-free municipal bonds.

That doesn't leave much wiggle room.

If you spend principal from taxable investment accounts, that isn't other income. If you borrow money from a life insurance policy, that isn't other income. If you sell your house and spend the equity, that isn't other income. If you refinance your house and borrow equity, that isn't other income. And, if you withdraw money from a Roth IRA account, that isn't other income. That's why I believe younger workers need to build home equity rapidly and diversify both their investments and their "portfolio" of investment accounts.

On the web:

I.R.S. Publication 915 on Social Security Benefits

Earlier columns on this subject:

Tuesday, April 12, 2005: Putting the Squeeze on Future Retirees