Third, by holding such a disproportionately large percentage of their net worth in their taxable bucket, this couple was creating a tax liability that was growing and compounding with each passing year. As tax rates climb, the real rate of return on those CDs begins to fall.
Lastly, since the pre-tax investment income from CDs is counted as provisional income, this couple was unwittingly causing their Social Security benefits to be taxed. Not only were they surrendering a portion of their investment growth to taxes, they were surrendering a portion of their Social Security as well.
Some people are tempted to put nearly unlimited amounts of money into the taxable bucket. They do so because it’s liquid, it tends to be safe, and it gives them peace of mind in the event of an emergency. But all these perceived benefits come at a high cost. At the end of the day, the primary purpose of the taxable bucket is to provide a cushion against life’s emergencies. That’s it, nothing more. By surrendering to the impulse of having more than six months’ worth of expenses in this bucket, you hinder the growth of your investments and create a laundry list of unintended consequences for your finances now and in the future. By having too much money in this bucket, you make it nearly impossible to be in the 0% tax bracket in retirement.
* Matthew Dallek, “Bipartisan Reagan–O’Neill Social Security Deal in 1983 Showed It Can Be Done,” US News, April 2, 2009, http://www.usnews.com/opinion/articles/2009/04/02/bipartisan-reagan-oneill-social-security-deal-in-1983-showed-it-can-be-done.
THREE
THE TAX-DEFERRED BUCKET
The tax-deferred bucket is likely the one with which you are most familiar. Chances are, you’ve been contributing to it your entire working life. If that’s the case, you’re not alone. The tax-deferred bucket has become the default investment account for most Americans, primarily because of the ease with which contributions are made. In the case of a 401(k) and other employer-sponsored plans, money gets zapped right out of your check and into a mutual fund portfolio. Out of sight, out of mind—what could be better? Throw in a matching contribution from your employer and it seems like a no-brainer.
However, as with your investments in the taxable bucket, there are unintended consequences of having too much money in tax-deferred accounts. In this chapter, we will explore all of the pros and cons of investing in tax-deferred accounts, and we will identify the ideal balance necessary to achieve the 0% tax bracket in retirement.
The tax-deferred accounts with which Americans are most familiar are 401(k)s and Individual Retirement Accounts (more commonly known as IRAs). Other tax-deferred accounts, such as 403(b)s, 457s, SIMPLES, SEPs, and Keoghs, have different rules that apply to them, but they all generally have two things in common:
Contributions are tax-deductible. Generally, when you put money into this bucket, you get a tax deduction. For example, if you make $100,000 this year, and you put $10,000 into your 401(k), your new taxable income is $90,000.
Distributions are treated as ordinary income. When you divert a portion of your income to a tax-deferred investment, all you’re really doing is postponing the receipt of that income until a point in time much further down the road. When you take the money out, you pay taxes at whatever the rate happens to be in the year you make the distribution. For that reason, the IRS calls these distributions ordinary income and taxes them accordingly.
When you contribute money to a tax-deferred account, it’s a bit like going into a business partnership with the IRS. The problem is, every year the IRS gets to vote on what percentage of your profits they get to keep. So, you could have $1,000,000 in your IRA today, but unless you can accurately predict what tax rates are going to be in the year you make a distribution, you really have no idea how much money you have. And it’s pretty hard to plan for retirement if you don’t know how much money you have.
Your Tax Bracket in Retirement: Higher or Lower?
Now, some people might say, “Don’t worry; it’s OK to have all your retirement savings in the tax-deferred bucket because, when you retire, you’ll be in a much lower-income tax bracket than you were during your working years.” Ever hear a financial “guru” say that? Well, it’s high time we put this claim under the microscope. As we discussed in the first chapter, the federal government has hugely underfunded liabilities in Social Security and Medicare programs due to changing demographics. In addition, tax rates over the past 20 years have been at historically low levels. Low tax rates and big deficits are a toxic combination that is driving our national debt to dangerously high levels. In order to liquidate all this debt, the government will have to raise more revenue.
Yet, even if we worked under the increasingly far-fetched assumption that taxes in the future are going to be the same as they are today, this much would still be true: All the deductions you experienced during your working years literally vanish into thin air right when you need them the most—in retirement.
Let’s take a look at the top four deductions during a typical American’s working years:
Mortgage Interest: This is far and away the number one source of deductions for those who itemize. Every year, you can deduct interest on up to $750,000 of debt on your residence. But here’s the problem: Most of the retirees I see week in and week out already have their home paid off. So, the biggest source of deductions is nonexistent for many retired Americans.
Your Children: This is a huge source of savings because your children count as a tax credit. A credit is far more valuable than just a deduction. A deduction is a dollar-for-dollar reduction in your taxable income, but a credit is a dollar-for-dollar reduction in your tax bill! In 2018, you get a $2,000 tax credit per child! Are your children still living with you in retirement? You hope not, right? But even if they are, they’re likely well past the age when they can be counted as dependents.
Retirement Plan Contributions: Are you still contributing to your 401(k) or IRA in retirement? Of course not! The whole reason you had these accounts was so that you could take money out in retirement, not continue to make contributions for the purpose of tax deductions.
Charity: Once charitable, always charitable. But what I’ve found is that, during retirement, there’s less money to go around. So instead of donating money, people donate time. In lieu of making that check out to the soup kitchen, they might actually go down to the soup kitchen and ladle the soup themselves. And while this is incredibly noble and worthwhile, it simply doesn’t show up on the IRS’s radar. Not a deductible activity!
All of these deductions during your working years might have added up to $50,000, $60,000, or in some cases $70,000. But absent any of these deductions in retirement, what’s left? The IRS, in their infinite goodness, gives you a choice. You can add up all the above-mentioned deductions (and other miscellaneous ones) and use that total to offset your taxable income. This is known as itemizing. Or, you can take the standard deduction, which, in 2018, is $24,000. Because many of the itemized deductions phase out before retirement, most retirees are stuck with the standard deduction.
So, if you need $120,000 per year of income in retirement and your deductions are only $24,000, then your taxable income would be $96,000 per year. That puts you at a marginal federal tax rate of 22%. Throw in another 6% (on average) for state tax, and you’re looking at a marginal tax rate of 28%. That’s a lot higher than most retirees are anticipating!
I can remember hearing an exchange on a financial radio show that went a little like this:
Caller:
I don’t understand. I have less income in retirement than I did during my working years, yet I’m paying more in taxes. How is that possible?
Host:
Tell me about your deductions.
Caller:
Deductions? I ran out of those a long time ago.
Host:
&
nbsp; I see. I think I know your problem…
It all comes down to deductions. Even if tax rates in the future are the same as they are today, you could still end up in a higher-income tax bracket in retirement than in your working years!
What Do You Truly Believe About Future Tax Rates?
Deciding whether to contribute to your tax-deferred bucket really comes down to what you think about the future of tax rates. If you think that your tax rates in the future are going to be lower than they are today, you should put as much money as you possibly can into tax-deferred investments. Get the tax deduction at today’s higher rates and pay taxes at a lower rate down the road.
If, conversely, you believe that tax rates in the future will be higher, even by 1%, then mathematically you are better off limiting your contributions to this bucket. Later in this chapter, we will discuss the circumstances where contributions to the tax-deferred bucket may be a smart decision.
The Catch-22 of Tax-Deferred Retirement Plans
To further explore the pitfalls of the tax-deferred bucket, I’d like to reference Joseph Heller’s Catch-22. The underlying theme of this famous book can help shed some light on the true nature of tax-deferred accounts.
The main protagonist in Catch-22 is named Yossarian. He and his friends serve in bomber crews during World War II, stationed at an air base off the coast of Italy. One by one, his friends fly into battle, get shot down, and never come back. Soon, Yossarian begins to realize that if he continues going on these bombing missions, he too will be shot down, and never come back.
So he begins to study the Air Force rules and regulations. And he comes across rule number 22. Rule 22 says that if you can successfully plead insanity, you can get honorably discharged from the Air Force. He decides that this is what he should do. So, he goes up to the Air Force physician and asks to be released from duty on the grounds of insanity. However, the physician says that the fact that Yossarian is trying to get out of flying these bombing missions is actually proof that he is perfectly sane. Therefore, he must continue to go on these bombing runs. Thus the title Catch-22. Do we still use the phrase “catch-22” today? You bet we do. It’s like being stuck between a rock and a hard place. Darned if you do, darned if you don’t. I refer to this story because any investment in the tax-deferred bucket is a perfect modern-day example of a catch-22. Here’s what I mean:
The Rock: You have to remember that the IRS wants to tax you on your money so badly that, at a certain point, they will force you to take money out. This happens at age 70½, and it’s called a Required Minimum Distribution (RMD). If you forget or choose not to take the money out, the IRS imposes what’s called an excise tax. In reality it’s a penalty, and it’s an astounding 50% of your RMD. In other words, if you were supposed to take out $10,000 but didn’t, you would get a bill in the mail for $5,000. And that doesn’t even include the income tax! Throw in another 30% (24% federal and 6% state) for that, and you’re looking at forfeiting 80% of whatever you were supposed to take out but didn’t. As you can see, the IRS is pretty serious about getting their money.
The Hard Place: Now we understand what happens if you don’t take enough money out of your tax-deferred investments. But what happens if you take out too much? Beyond paying increasingly higher amounts of tax, the IRS says that as much as 85% of your Social Security becomes taxable. What?! you may be thinking. Social Security felt like a tax when it came out of my paycheck, and now they’re going to tax it before I get it back? That’s like a double tax! Sadly, you read correctly.
The Bottom Line: If you take out too little, you will pay a big penalty to the IRS. If you take out more than required, you pay higher taxes on your Social Security benefits. Talk about a catch-22!
The Dirty Words of Retirement Savings: Provisional Income
As I explained in the previous chapter, Social Security benefit taxation was the result of a compromise struck between President Ronald Reagan and Speaker of the House Tip O’Neill back in 1983, when Social Security was teetering on the cusp of insolvency. Under the Reagan–O’Neill deal, up to 50% of Social Security benefits were subject to tax. At the beginning of President Bill Clinton’s first term in 1993, the tax was expanded so that up to 85% of Social Security benefits became taxable, depending on income levels.*1
Here’s how it works. As you’ll recall from Chapter 2, the IRS tracks something called provisional income to determine the percentage of your Social Security that will be taxed. Anyone aspiring to the 0% tax bracket should be acutely aware of what qualifies as provisional income. The following is a list of the most common sources of provisional income:
One-half of your Social Security income
Any distributions taken out of your tax-deferred bucket (IRAs, 401(k)s, etc.)
Any 1099 or interest generated from your taxable-bucket investments
Any employment income
Any rental income
Interest from municipal bonds
The IRS adds up all your provisional income and, based on that total and your marital status, determines what percentage of your Social Security benefits will become taxed. That percentage of your Social Security benefits is then taxed at your highest marginal tax rate. The provisional income thresholds are outlined below.
Unfortunately, these tax thresholds are not indexed for inflation, so each year an increasing number of retirees begin to pay taxes on a portion of their Social Security benefits.
To better understand how devastating this tax can be, let’s look at the example of Tom and Mary Smith. Tom and Mary have a combined $30,000 of Social Security income. They also distribute $80,000 from their IRA in an effort to meet their lifestyle needs in retirement. In order to determine their provisional income, the IRS takes half of their Social Security ($15,000) and adds it to the $80,000 that they distributed from their IRAs. So, Tom and Mary’s total provisional income is $95,000. Because of their high provisional income, 85% of their Social Security is now taxable at their highest marginal tax rate. Thus, 85% of their $30,000 of Social Security is $25,500. This amount now gets piled right on top of all their other income, at which point they pay federal tax (say 22%) on $25,500, for a total of $5,610. So, Tom and Mary just paid a $5,610 tax on their Social Security, simply because they took too much money out of their IRA. Every year in which they continue to take this level of distributions from their IRA is another year they pay tax on their Social Security.
To make matters worse, Tom and Mary now have to compensate for the $5,610 that they are no longer getting from their Social Security. To do so, they will likely have to take an additional distribution from their IRA—yet another taxable event. If Tom and Mary’s marginal tax rate is 28% (including 6% state tax), they’d have to take $7,792 from their IRA, just to replace the $5,610 that they lost to Social Security taxation! Wouldn’t it be much simpler if Tom and Mary could get their Social Security tax-free? We will discuss how to do this in Chapter 5.
So, this is the catch-22 of traditional tax-deferred retirement accounts. Darned if you don’t take enough money out (you incur a 50% penalty) and darned if you take too much out (your Social Security gets taxed).
A Math Formula That Could Sink Your IRA or 401(k)
To make matters worse, many Americans will run out of money in their 401(k)s and IRAs much faster than they think, and it’s all because of a math formula that they never taught us in high school.
Let me illustrate this point by posing a math problem. Let’s say that Tom and Mary need $100,000 after tax from their IRA to support their lifestyle in retirement. If Tom and Mary are at a 30% effective tax rate,*2 how much will they have to take out of their IRA to be able to pay the tax to the IRS and still be left with $100,000 that they can then spend on their lifestyle? I’ve asked this question to thousands of people across the country, and you know the answer I get 90% of
the time? $130,000. Now, on the surface this answer makes sense. Thirty percent of $100,000 is $30,000, right? Add that to the $100,000 you need to pay for your lifestyle, and there’s your answer. But is that really how it works?
It’s a little bit more complex than that. If you pay 30% in taxes, then you get to keep 70%. However, 70% of $130,000 is only $91,000, which leaves you $9,000 short. To get the correct answer, you have to use a special formula. Take the amount of money you need after tax ($100,000) and divide by 1 minus your effective tax rate (.30). In mathematical notation, it looks like this:
$100,000
(1−.30)
In essence, we’re dividing 0.7 into $100,000. When we do, we get $142,857. That’s $12,857 more than most Americans think. In other words, when the typical American calls up his financial advisor and says, “I need $100,000 after taxes,” he thinks that his balance is going to go down by $130,000. In reality, it’s going to go down by $142,857. Is it possible that quite a few Americans will be running out of money in their 401(k)s or IRAs a lot faster than they thought? It sure is, and it’s all because of a simple math formula that we never learned in school.
The Power of Zero, Revised and Updated Page 3
