Friday, February 22, 2013

Reducing Taxes on Social Security Benefits: Part 3

In my first blog on this topic, Will Your Social Security Benefits Be Taxed?, I explained who will pay taxes on their Social Security benefits and who won’t. People whose retirement income comes almost entirely from Social Security won’t pay the tax.

Eventually, just about everyone else will because, like the Alternative Minimum Tax, the limits that trigger the tax are not adjusted for inflation.

In my second post, Calculating Taxable Social Security Benefits, I explained how the tax is calculated. Understanding how benefits are taxed is the precursor to understanding how the taxes might be reduced or avoided.

As I explained in the first two posts, nearly every form of income except Roth IRA distributions is included in the calculation of combined income that determines how much of your benefit will be taxable. Avoiding the tax isn’t as easy as avoiding income tax by investing in municipal bonds, for example.

There are, however, some tactics to consider that may reduce the taxability of your Social Security benefits by reducing future combined income.

Work Less

If earnings from part-time work after you retire is pushing you over the limit and making your Social Security benefits taxable, you could consider working (and earning) less to drop back down below the thresholds. Remember, though, that only the amount of combined income that exceeds the thresholds is taxed, so avoiding the taxes you would owe may not justify working less. You have to do the calculations.

Invest in Annuities

Annuities defer capital gains until you start withdrawing from them, so they won't increase the amount of your Social Security benefits that are taxable until then, either. I don’t like variable annuities as investments, but they might help with Social Security benefit taxes, depending on your situation. In general, I think taxes should be a secondary part of investment decisions and there are generally better investment vehicles available than variable annuities.

Traditional IRAs

Traditional (non-Roth) IRA’s are a mixed blessing.

Your earnings will compound inside the account without being taxed until you take distributions from them. This will protect them from income taxes before you begin receiving Social Security benefits. After you begin receiving benefits, a traditional IRA will protect earnings from making those benefits taxable. You can avoid income tax and taxable benefits simply by leaving the money in your IRA. . . until you are age 70 ½.

At age 70 ½, however, you must begin withdrawing Required Minimum Distributions (RMDs) from all traditional IRA accounts, so you can no longer hide them from regular income tax or exclude them from combined income. They will then count toward making a portion of your Social Security benefits taxable.

RMDs are calculated as a fraction of your IRA balance ever year after age 70 ½.  April 15th of the year after turning 70 ½, you will be required to withdraw 3.6% of your IRA balance whether you need it or not. The percentages decrease every subsequent year.

Should you decide to leave your money in your IRA after you retire to avoid taxes, and to continue tax-deferred earnings, there is a good chance (you hope) that your IRA balance will increase over the years. More money is good, but the even-larger RMDs you are creating may not be. They could make your Social Security benefits taxable, the so-called "Tax Torpedo" that I explained in the first two blogs on this topic.

Roth IRAs

Roth IRAs are the golden boys of retirement income taxes. You paid taxes on the money before you saved it in the Roth and from then on earnings were not taxable, nor are distributions, and distributions do not increase Social Security benefit taxability.

If all of your retirement income came from Social Security benefits and Roth IRA’s, Social Security taxes would not be a concern for you.

Under certain circumstances, you can convert IRA dollars into Roth dollars. To do so, you have to pay income taxes on the money when you take it out of the IRA and that may or may not improve your finances over the long run, depending on your specific situation.

Should You Convert?

If Roth IRAs are so wonderful after you retire (traditional IRAs were better before you retired because you got a tax deduction on the savings), why not convert as much of your IRA to Roth as you can?

Maybe, you should. But you need to consider the pros and cons.

When you save in a traditional IRA, you invest earnings and defer paying taxes on them until you withdraw that money. You can withdraw it over a very long time (but beginning no later than age 70 ½), so you can stretch out those tax payments. Bottom line, with an IRA, you pay taxes when you withdraw money.

Also notice this means that the longer you live, the more tax you will pay on IRA withdrawals. Should you take RMDs and only live to age 72, for example, you would only pay taxes on about 8% of your IRA balance.

A Roth is just the opposite. You fund a Roth with earnings that have already been taxed, but you don't have to pay taxes when you withdraw from the account.

So, is it better to pay taxes up front or at the end? Actually, there is no difference if the tax rates are the same at both times, but if your taxes are higher before you retire, a traditional IRA will come out ahead. If your taxes are higher after you retire, a Roth will come out ahead.

Unfortunately, your future tax rates are unpredictable. Consequently, many advisers suggest you save some in each type of account to diversify your outcomes.

I have used consumption smoothing software to evaluate Roth conversions for some clients and found that the outcomes ranged from a loss of about 1% of standard of living to a gain of 1.6% if they converted IRA funds to a Roth IRA. That is a meaningful, yet not dramatic, difference. 

I have also noticed that papers written on the subject of Roth conversions never consider how long you will live, but this makes a dramatic difference. It is possible that you will not live long enough to realize the tax savings of converting to a Roth.

Should you die before you would have withdrawn from an IRA, the taxes you would pay to convert go for naught. And since traditional IRA withdrawals can be stretched out for many years, the longer you live the more tax you will pay. How long you live can make a big difference in the outcomes.

Imagine that you are 55 years old and decide to do a Roth conversion. You pay $25,000 income tax on the money you convert from your IRA. You plan to begin IRA distributions at age 70, but die at age 65. That’s $25,000 you paid in taxes that you never would have had to pay and perhaps 6% a year of compound interest you might have earned on that $25,000 also lost. (At 6% a year, that $25,000 would have grown to $44,771 in 10 years.)

You have to run the numbers (better yet, have a tax expert run them) to predict (not determine) whether your future (possibly) higher tax bill might justify pre-paying taxes on the conversion amount and forgoing future earnings on the amount of those taxes.

I like using consumption smoothing software to see if it will significantly impact your standard of living, but in my experience, the arguments for converting are rarely compelling.

In my next post, I’ll describe an alternative strategy recommended by many advisers that combines tactics for maximizing Social Security benefits, maintaining control of your capital and its growth, reducing RMD that maybe helps you reduce those Social Security benefit taxes without paying taxes today.

Monday, February 18, 2013

Why Old People Complain About Gas

It’s not uncommon to hear Americans complain about gasoline prices and, of course, older people complain more. That's because we are old enough to remember when the nominal price of gasoline was like, 29¢ a gallon, so $3.40 a gallon in 2013 seems outrageous.

(Nominal prices are not adjusted for inflation. Real prices are.)

Nominal or real, gasoline prices per gallon are high today — they’re well above the real long-term average cost of about $2.00 a gallon since 1931. 

In this chart from, the red line shows the real price of a gallon of gas since 1931.

We perceive that the price of gasoline is constantly rising (the black line) because we see inflated prices. But, the real cost of gasoline per gallon is all over the place, highest in 1918 and 1981 and lowest in 1999.

When I saw one of my high school classmates bemoan the high price of petrol on Facebook today, I decided to research a few comparative prices that that my classmates from Elizabethtown High School (Go Panthers!) would’ve seen the year we graduated, 1970. Here’s what I found:

It costs about $5.91 to purchase in 2013 what we could've bought for $1.00 in 1970. To ease the confusion, I'll state all amounts that are expressed in 1970 dollars in purple and all amounts expressed in today's dollars in gold. (Yeah, EHS school colors.)

Let me explain the columns of this table by looking at the top row (click to make it larger). 

When I went to the University of Kentucky with several of my EHS classmates in 1970, I paid a whopping $165 per semester for tuition. This year, my alma mater’s tuition is $4,978 per semester.

(But that includes basketball tickets, so it’s still a steal).

That’s a nominal price increase of 2,917%, but a lot of that is not real — it’s the result of inflation. If I squeeze out the inflation portion by restating the 2012 price in 1970 dollars, I get $841 instead of $4,978. In other words, $841 in 1970 had the same purchasing power that $4,978 has today.  So, the real increase in price is not 2,917%, but 410% (from $165 to $841).

Still an awful lot, compared to 1970, for in-state tuition at a state university.

As the table shows, health care and the cost of tuition at UK have increased far faster than the average American worker's income (row 3).

Both the average cost of four years of college in the U.S. and the median home price (after the real estate crash) have increased a lot faster than general inflation but less than average incomes.

Gasoline prices haven’t increased as fast as tuition, homes, health care or college, or as fast as average incomes, but they have outpaced general inflation.

In 1970, gas averaged $0.36 a gallon. A college kid earning minimum wage of $1.60 an hour in 1970 could work one hour and buy 4.4 gallons. (Remember saying, "I'll take a dollar's worth of regular"?)

A minimum wage earner in 2013 earns $7.20 hourly and can buy 2.1 gallons at $3.40 per gallon with an hour of work (while having no one to say, "I'll have a dollar's worth" to).

On the other hand, gas mileage for the U.S. auto fleet has improved from 13.75 mpg in 1970 to 32 mpg in 2013 (it took 3 gallons of gas just to start my '68 Chevelle SS 396).

Looked at from that perspective, an hour of minimum wage labor in 1970 would have purchased an average of 61 miles driving a car that got 13.75 mpg. That same hour of minimum wage labor in 2013 would purchase 68 miles of driving at 32 mpg today.

From a consumption perspective, the cost of gasoline per year has actually decreased a bit. We pay about twice as much for a gallon now in real dollars, but that gallon takes us about 2.3 times as far.

We fare even better if we look at the average hourly pay rates for 1970 ($3.41) and 2012 ($19.97) instead of the minimum wage. For someone earning the average wage instead of minimum, an hour of labor in 1970 bought enough gas to travel 130 miles while an hour of labor in 2012 bought enough gas to travel 188 miles.

For one last example from my youth, consider the drive home from UK in Lexington to Elizabethtown (still 85 miles after all these years) that my EHS buddies and I made many times. In 1970, that trip would have used about 6.18 gallons of gas at a cost of $2.23. Today, the trip would require 2.7 gallons at a cost of $9.18. But nine dollars in 2013 is only about a buck and a half in 1970 dollars and that's 31% cheaper.

If I drove a Prius from school in Lexington to E-town today I would get 50 mpg and it would cost $0.92 for gas in 1970 dollars — less than half what it cost in 1970 — and many of my classmates would laugh at me for driving a hybrid.

So, whether you consider minimum or average wage rates, while the cost of a gallon of gas has gone up, the cost of enough gas to travel each mile has gone down due to better vehicle gas mileage.

Still, I'd love to have my '68 SS 396 back, even if I could only afford to drive it on Sundays. Just once, with the windows down in the spring and the 8-track blaring Grand Funk.

But, I digress. . .

Which brings us to line 9, the minimum wage.

I worked construction one summer while I was in college for a buck sixty an hour. Hardest job I ever had. Today, a minimum wage job would pay $7.25, but in 1970 dollars, that’s only $1.23. Real minimum wages have actually fallen 23% in value since I was in college.

A politician in our state recently asked why college kids take on so much debt today and wondered aloud why kids can’t just work their way through school like she did back in the 1970’s.

Lines 4 and 9 answer her question. College prices have grown 85% for a four-year education while the wages for the kinds of jobs a college kid might get have actually fallen 23%.

I paid my way through college. I had to work 103 hours at $1.60 per hour to pay for one semester of college tuition. A college student today would have to work 687 hours at $7.25 to pay for one semester of tuition at UK.

And that’s just tuition. It doesn’t include books, room and board, or beer!

If I subtract 5.5% FICA taxes for 1970 wages and 7.65% for 2013, that's actually 109 hours I needed to work in 1970 and 743 hours my kids would need to work in 2012.

For every hour I had to work in 1970, they'd have to work nearly seven now.

So, yeah, gas prices are high, but so are a lot of other things. While the price of a gallon of gas has risen since 1970, the cost of a "mile's worth" of gasoline has actually dropped.

At least we have some personal control over gasoline expenses. My family bought a Prius last year and we cut our annual gasoline bill in half.

With two kids in college and one in med school, I wish Toyota could build a hybrid to halve tuition costs.

Thursday, February 14, 2013

Calculating Taxable Social Security Benefits

In my last post, Will Your Social Security Benefits Be Taxed?, I promised to show you how to calculate combined income in greater detail. Combined income is the number that determines how much of your Social Security benefits, if any, will be taxed. As I explained in that post, the basic equation is this:
The following diagram shows some of the types of income included in combined income. Almost all income will be, including tax-free interest. (The list of AGI items is representative, but not complete.) About the only income not included in combined income is a distribution from a Roth IRA account.

The core of combined income is Adjusted Gross Income. Perhaps the best way to get an understanding of AGI is to look at the first page of your Form 1040 from last year (or this blank form). AGI will be the last line on the first page. That’s line 37 for 2011 returns.

AGI is calculated by adding up the rightmost column of the “Income” section at the top of the first page of Form 1040 and subtracting items from the “Adjusted Gross Income” section at the bottom. Notice that AGI includes all the blue items in the diagram above and more.

Tax-exempt (tax-free) interest is listed on line 8b of Form 1040, but is not included in the AGI total on line 37. It is, however, included in combined income.

Combined income also includes half your Social Security benefits. Line 20b is where you would enter taxable Social Security benefits.

In 2011, your combined income would have been the sum of lines 37 and 8b from the first page of your Form 1040, plus half your Social Security benefits.

While you can easily figure your combined income with this calculator, it’s handy to understand how the amount is determined. There are two base amounts for combined income depending on your marital and filing status. The following diagram shows the single return filer base amounts on the left and married-filing-jointly base amounts on the right.
Let’s pretend this diagram is a bucket and you are a single filer. To determine how much of your Social Security benefits are taxable, you would calculate combined income as I explained above and then “pour” this combined income into the bucket.

The portion of your combined income in the green part of the bucket will result in no taxation of your Social Security benefits. 

$0.50 of every dollar of combined income that rises into the pink area will be taxable. 

Should your combined income fill the bucket into the red area, $0.85 of every dollar that rises into the red area will be taxable and $0.50 of every dollar in the green area (all $9,000 of them) will be taxable.

For example, if you had $34,100 of combined income, your taxable Social Security benefits would equal 50% of $9,000 plus 85% of $100, or $4,585. $27,000 of combined income would result in 50% of $2,000, or $1,000 of your Social Security benefits being taxed.

There are a couple of important things to note here that might seem obvious to you, but have caused some confusion for many.

First, what we just calculated is the amount of your Social Security benefits that will be taxable, not the amount of the tax. The IRS isn’t going to take 50% or 85% of your benefits in taxes. That amount is added to your taxable income and the amount of taxes you will pay depends on your tax bracket.

In the first example above, if you calculated that $4,585 of your Social Security benefit would be taxable and you were in a 15% tax bracket, your actual additional tax would be 15% of $4,585, or about $688.

The second thing to note is that only the portion of your combined income that exceeds the base amount is taxed. Exceeding the $25,000 hurdle doesn’t automatically render 50% of your benefits taxable. If you have $25,001 of combined income, only 50% of one dollar of your benefits becomes taxable.

What does this do to your marginal tax rate, the amount of tax you pay on the last dollar of income you receive? This depends on what your marginal tax rate would be if no Social Security benefits were taxable. Your new marginal tax rate will be 150% of that rate if you exceed only the first base amount and 185% of that rate if you exceed the second. A 25% marginal tax rate would increase to 37.5% in the first case and 46.3% in the second. State taxes may increase these rates further.

The structure of the tax tables limits married-filing-jointly marginal tax rates to 27.75%, so only those filing single returns are subject to that monster 46.3% marginal rate that could exceed 50% when you add state taxes.

It’s complicated to be sure, so use a calculator like this one to play around with the possibilities and consult a tax professional to develop a plan to minimize your taxes.

In my next post, I’ll discuss some ways you might minimize the impact of taxable Social Security benefits.

Saturday, February 9, 2013

Will Your Social Security Benefits Be Taxed?

Most people don’t think about having to pay income taxes on Social Security retirement benefits after they retire. Most of us won’t have to pay them.

But many of us will. If you begin receiving Social Security benefits and you have saved a lot for retirement or have a job, you may see a dramatic increase in your marginal tax rate.

Who Won’t Have to Pay?

If you haven't saved enough for retirement and all or most of your retirement income will come from Social Security benefits, your benefits won’t be taxed. That's good news and bad, of course.

The bad news is that you would no doubt prefer to have a lot of money so taxes could be your biggest problem.  The good news is that you won’t pay taxes on your Social Security benefits and you won't need to read the mind-numbing tax discussion in the rest of this post.

(For your sake and mine, I hope you’re still with me.)

What Could Make your Benefits Taxable?

Technically, nearly any form of income in addition to Social Security benefits except Roth IRA distributions could push you over the limits, but here are some likely culprits:
  • Large IRA account balances, especially after age 70 ½
  • Large taxable (non-retirement) account balances
  • Large investments in municipal bonds
  • Pensions
  • Employment
  • Inflation (more on that in a minute)
In fact, unless you have a fairly large retirement savings portfolio (perhaps $250,000 or more) or you are employed after you begin receiving benefits, you probably won’t pay taxes on your Social Security benefits. Income from a job or distributions from a large retirement account, however, can push you to the level of income where Social Security benefits become taxable. Perhaps painfully so.

When Do Benefits Become Taxable?

If your “combined income” exceeds a “base amount” of $25,000 a year and you are single (or $32,000 and married filing jointly), some of your Social Security benefits will be taxed.

What is “combined income”? There’s a good chance that you’ve never heard of it.

The Social Security Administration defines combined income as the sum of half your Social Security benefits plus Adjusted Gross Income from your federal income tax return plus non-taxable interest.
For example, if you receive $12,000 a year from Social Security retirement benefits, have an adjusted gross income of $10,000, say from interest and dividends, and earn $4,000 in tax-free municipal bond interest in a given year, your combined income will be:
You would fall below the $25,000 lower base amount and none of your Social Security benefits would be taxable that year. Here's a nifty calculator if you want to play with the numbers.

Adjusted Gross Income (AGI) is basically the sum of all your annual income including wages, capital gains, dividends, pensions, interest, IRA distributions and just about any other taxable income source. AGI doesn’t include tax-free interest, but combined income does. When you add tax-free income, combined income includes just about every form of income you might have, except for Roth IRA distributions.

Traditional IRA distributions are included in AGI, so when you take money out of your IRA, which you will eventually have to do, it might push your Social Security benefits into a taxable bracket. 

Distributions from a Roth IRA are not included in combined income. They’re about the only safe refuge.

In other words, it’s very difficult to protect income from contributing to Social Security benefit taxability. You can’t just invest in muni’s like you do to avoid federal income tax before you receive benefits.

(I’ll show you how to calculate combined income in more detail in my next post.)

Taxing Benefits Increases Your Marginal Tax Rate

Why is this a problem? When Social Security benefits become taxable, the additional taxable income can push your marginal tax bracket significantly higher. Your marginal tax bracket can increase to over 50% when you include state taxes, but it is more likely to increase 20% to 30%, and less in some cases.

This is also important because you must begin taking Required Minimum Distributions (RMDs) from your IRA accounts when you reach age 70 ½. That additional income could cause your Social Security benefits to become taxable. The net effect, a high marginal tax rate created when mandatory IRA withdrawals make your Social Security benefits taxable, is sometimes referred to as the “tax torpedo”, but that’s a long story for another post.

Inflation Will Catch More and More Households

Another important consideration when thinking about the taxability of Social Security benefits is inflation. While Social Security benefits are generally increased to compensate for inflation, those base amounts ($25,000/$32,000 for single and $32,000/$44,000 for married filing jointly) are not.

If inflation runs 3% a year for the next 10 years and Congress doesn’t change the law, that lower limit will be $18,600 in today’s dollars. In 20 years it will be less than $14,000. Your retirement could last even longer than that and that limit will become easier and easier to surpass.

As with the Alternative Minimum Tax, the number of households paying taxes on Social Security benefits will increase over time.

Avoiding Social Security Taxability is an Annual Battle

Social Security benefit taxability is calculated every year. Benefits may be taxable one year because you take some large capital gains but not taxable the next year when you don’t. They may not be taxable when you are 65 and leaving your IRA untouched, but taxable when you are 71 and forced to take RMDs.

I’m not a tax expert, but if you believe your benefits might become taxable, I would suggest you find one to help with your retirement planning. There are steps you can take to reduce these taxes, like converting to a Roth IRA, delaying Social Security benefits, and changing the order in which you spend from taxable, tax-deferred and Roth accounts. Which steps to take depends heavily on your own situation, so do the analysis before deciding. Better yet, have a tax expert analyze it.

Taxability of Social Security benefits is one more good reason to delay receiving benefits as long as you can if you have substantial retirement savings — those benefits won’t become taxable, of course, until you start receiving them.