BeaconMediaNews.com
4 | SEPTEMBER 26, 2013 - OCTOBER 02, 2013
Smart Women Smart Money
By Emmy Hernandez Certified Financial Planner® Practitioner Attorney at Law Emmy, I’m retired and living mostly off Social Security. Last year, I withdrew a fairly large amount from my IRA. Because of this, my benefits will be taxed this year. I feel blindsided! Why is this? I thought Social Security benefits were tax free as they were taxed from my income years ago. I do understand your surprise and frustration. Many people who have their taxes done by a third party are unaware that their Social Security benefits may be taxed. Often, it’s not until someone completes the Social Security Benefits Worksheet to calculate the correct figure for line 20b of their 1040 that the truth comes out. (Eek, that last sentence made me sound like a bit of a tax geek.) Some history: this tax was initiated by the Reagan administration’s Social Security reforms in 1983. Before then, everyone received their benefits tax free. Yes, you did indeed originally pay into the program as a tax on your earned income. However behind the scenes, your employer also paid an equal amount each month and
that money was not taxed. Today, the tax rate on Social Security benefits is determined by your taxable, or provisional, income. For most households, provisional income is your Adjusted Gross Income, plus tax-exempt interest income, plus half of your Social Security benefits. (Foreign-earned income and higher education costs can also be factored in.) Think of that taxable 50% of your benefits as the untaxed portion that your past employers paid into the system. The 1983 law established a baseline of $25,000 for individuals and $32,000 for married couples. If your provisional annual earnings fall below this baseline then your benefits remain tax free. However, once this threshold is crossed, things change. Up to half of your annual benefit amount now becomes taxable. The additional monies you withdrew from your IRA very likely brought you above that baseline. Folks with large required minimum distributions from their IRAs face this problem. Likewise, benefit recipients who choose to take on a part-time job for extra income. In 1993, under President Clinton, another threshold was created: $34,000 for individuals and $44,000 for married couples. If you cross this second line, then up to 85% of your benefits can be taxed! Although I am loathe to add more fuel to the fire, there is yet another factor that stings: these two income thresholds are not indexed for inflation. In 1983, $32,000 in annual retirement income for a married couple offered a higher living standard than today. Likewise,
$44,000 was an impressive amount in 1993. Then, far fewer people were affected by these thresholds for taxing Social Security benefits. Now many retirees face this tax. Unfortunately, most are unaware of it. As a point of reference, in 1984 the tax on Social Security benefits brought $2.8 billion back into the Social Security system. But last year, the tax yielded $26.7 billion. There are different strategies to help avoid being taxed more than necessary on Social Security benefits. Ultimately, you want to keep your provisional income under the taxable limit. One option is to convert a traditional IRA to a Roth IRA. Income from Roth accounts is not included when calculating the provisional income affecting the taxation of Social Security benefits. Please be aware that such a conversion is considered a withdrawal from a traditional IRA and 401(k). This financial transfer is counted as taxable income and will greatly add to your tax liability for the year it’s implemented. But, taking the onetime tax hit might be worth it. By converting, you could reduce the tax burden on future Social Security benefits. The goal is to plan ahead to lesson your tax burden. Every family’s situation differs and any tax deferral strategy must be tailored to suit those needs. The rollover option I’ve outlined above is a generality. Please consult a qualified financial advisor before making any important decisions. I truly hope this information was useful. Let me end this week’s column by inviting everyone to attend an important Social Security
workshop I’m hosting at the San Gabriel public library on Saturday, October 12th at 10 am. Join me to learn how to help maximize your Social Security benefits and discuss potential tax saving strategies. I encourage you to reserve your seats by calling my office at 626943-8833. I hope to see you there. Securities and advisory services offered through NATIONAL PLANNING CORP (NPC) member FINRA, SIPC, a Registered Investment Adviser. EH Financial Group, Inc. and NPC are separate entities and unrelated companies. The relevant income for Social Security taxation includes all items which are normally part of your adjusted gross income, plus tax-exempt interest income, plus 50% of your Social Security benefits. (Historically, the 50% represents the fact that half of your Social Security contributions were made by your employer and thus not taxed.) [3] There are two relevant base amounts; unlike most income limits in the tax code, they are not adjusted for inflation. The lower base is $25,000 if you are single, $32,000 if married filing jointly. The upper base is $34,000 if you are single, $44,000 if married filing jointly.[4] If your relevant income is below the lower base, none of your benefits are taxable. For every $1 of relevant income between the lower and upper bases, 50 cents of your Social Security benefits become taxable, up to 50% of your total benefits. For every $1 of relevant income above the upper bases, 85 cents of your Social Security benefits become taxable, up to a total taxable
amount of 85% of your benefits.[5] Rate of taxation The bottom line: as income rises, more Social Security benefits are subject to taxation, until eventually a maximum of 85% of all benefits are included in income for tax purposes! The best thing to do may be managing income earlier to avoid exposure in the later years. For instance, Roth conversions before a client starts Social Security benefits can leave a more flexible pool of money to draw upon in the later years - not to mention avoiding RMDs - allowing the client to avoid 22.5%, 27.75%, or 46.25% marginal tax rates down the road. Of course, the caveat for Roth conversions is still not to do too much at once, driving up the current tax rate to an untenable level For lower-income retirees, less than 85% will be taxable, but many retirees in a 15% tax bracket will face a marginal tax rate much higher than 15%. the income levels where Social Security phases in - which can begin with as little as $25,000 of income for individuals - tax rates rise high enough that more proactive tax planning, from Roth conversions to the use of annuities and asset location strategies, becomes crucial to manage a client's overall tax exposure! Solutions You might consider accelerating income into one tax year or pushing off income to another year, says paying off a mortgage with cash savings could preserve benefits from tax. In the year you convert a traditional IRA to a Roth, your benefits will likely get taxed because a conversion adds to your
taxable income. You might consider doing smaller conversions over several years in amounts that take you to the top of your current tax bracket. Taking the one-time tax hit could be worth it. Withdrawals from a traditional IRA and 401(k) are counted as taxable income. By converting, you may eliminate or reduce the tax hit on future benefits. "Roth income is not counted in the Social Security taxation calculation," says Larry Rosenthal, president of Financial Planning Services, in Manassas, Va. Tax deferral Tax deferral strategies can also be appealing to manage Social-Securitytriggered higher marginal tax rates. This might not only include just continuing to maintain and stretch taxdeferred IRAs (to the extent they're not converted), but also the use of non-qualified fixed or variable annuities to defer income; while taxdeferral doesn't eliminate exposure to the effect entirely, it's nonetheless true that tax deferral itself is worth a whole lot more when the client's marginal tax rate is so high! Similarly,effective asset location strategies to shelter the most high-income tax-inefficient assets also become more important where client marginal tax rates are so high. Do you have a question for Emmy? Please submit questions or comments by email to smartwomen@ehfinancial.com or call 626-943-8833. Securities and advisory services offered through NATIONAL PLANNING CORP (NPC) member FINRA, SIPC, a Registered Investment Adviser. EH Financial Group, Inc. and NPC are separate entities and unrelated companies.
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