Planning for Retirement
One of the biggest obstacles you will face during retirement is something that I
have personally labeled “The Hump”, the 46.25% and 55.5% marginal tax rates which are
discussed in great detail in the following pages.
For now, let’s just look at this graph which roughly illustrates the differences
between working taxes and retirement taxes. The red line illustrates the normal 10%,
15%, and 25% tax rates we are all familiar with. The blue line illustrates your
marginal tax rates during retirement.
The green line is what you need to understand when planning for retirement. It
represents the taxes that you save, and then give back, because your Social
Security benefits are initially tax deferred income, you get it tax free at first,
then 85% of your benefits are slowly taxed in parallel as your other income
This table shows that we are not talking about individuals with high income levels.
A single individual with a $20,000 Social Security benefit and $35,297 of additional
taxable income from Pensions, Annuities, IRA withdrawals, etc. will have an after tax
income of $50,135 and will be faced with these huge tax rates for the next $3,409 of
taxable income. Living in retirement on $50,000 of spendable cash per year is not
exactly what most of us would call rich!
In 2002 the IRS adjusted the top end of the 10% and 15% tax brackets and the
standard deduction for married couples to be double the amounts for single
individuals. This basically eliminated the marriage penalty for most median income
working couples, but the marriage penalty still exists in the taxability points for your
Social Security benefits. This penalty only causes married couples to pay back their
tax savings earlier and is all but eliminated at income levels when single
individuals have also reached their full 85% taxability limit.
Balancing your income streams between taxable and non-taxable sources can be a
major factor in avoiding The Hump.
How your retirement savings will be taxed.
Social Security. In 1935 Social Security was originally designed to be tax
free. In 1983 and 1993 congress changed that to tax deferred which is what changes
the federal tax brackets into marginal tax rates.
Pensions. Payments from private and government pensions are usually taxable
at your marginal tax rate.
Annuities. The tax status of your annuity depends on the source of the funds
used to purchase it. If it was purchased from a traditional IRA is will be 100%
taxable, from a Roth IRA, probably 100% tax free. If it was purchased other funds,
your insurance company is required to tell you how much of the income is return of
principal and how much is taxable.
IRA / 401K. Withdrawals from traditional IRAs and your 401(k) will be taxed
as ordinary income, which means at your top marginal bracket.
Long Term Gains and Dividends. This income is also deferred and can raise
your marginal taxes to 55.5%. There is an entire journal page devoted to how and
why this is a good thing.
Short Term Gains and Interest. This income is taxed at your marginal tax
Municipal Bond Interest. This income is tax free at the federal level, but it
does increase the amount of deferred Social Security benefits that become
Roth IRAs. As long as the Roth has been open for at least five years and
you're 59 1/2 or older, all withdrawals are tax-free. In addition, you don't have to
take RMDs from your Roth when you turn 70 1/2. This journal includes multiple pages
that will explain how to convert your taxable traditional IRA into a tax free
Conventional wisdom has long held that an IRA / 401K is one of the best ways to save
for retirement. This strategy makes sense if your income levels are low and you will
not be faced with The Hump or if your Social Security plus Pension plus
taxable Annuity is so high that you are over The Hump tax situation.
If your planned retirement income levels place you close to or slightly into The
Hump area, you need to seriously consider ways to convert your retirement income
from taxable to tax free sources. The following journal pages are dedicated to
helping you to understand this situation.