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Preparing for Median Income Retirement

Disclaimer
This page was created using the 2016 tax brackets. The author is not a qualified tax accountant or investment advisor, so use this information at your own risk!

Preface
If your company has a 401K, you should always contribute enough to get the full company match, it is free money! In general, most people should also invest as much as they can afford in their 401K/IRA, but that is not always the best advice to everyone! I know this is a highly controversial statement, but in some cases this situation has to be corrected before retirement.

When your income levels are Median and lower, this is great advice. When you will take money out of your 401K during retirement at marginal tax brackets from 0% to 27.75%, the average tax cost will be well under the 25% you saved while contributing to your 401K. If you worked in a high tax state and retire to a lower or no tax state, this advice goes from being great to being fantastic.

When your income is well into the six figure range, this advice is relatively tax neutral because you are generally paying the same federal tax rate while working and while retired and it becomes profitable when you move to a lower tax state.

There is a small income range somewhere between Median and High income where your eventual Social Security plus other fixed income sources like pensions, annuities, etc. can put you in a situation where you will be paying considerably higher taxes when you take the money out than you saved when making the contributions.

This page is designed to help you determine if you are in that small range of income and give you some advice on things you might do to avoid this situation. More than 95% of those who read this page will find it worthless. But, if you are among the 5% who are facing this situation, this page can literally save you thousands of dollars each of your retirement years!

Tax Brackets
Let’s start this discussion with the old cliché: A picture is worth a thousand words.



The blue line in this picture represents the normal tax brackets that you currently face during your working years. It has been enhanced with a small amount of Long Term Capital Gains or Qualified Dividends to show how this class of income changes the normal tax brackets. This income is initially tax deferred, then when it is pushed into the normal 25% brackets it is taxed at 15% at the same time as the income that pushed it into that bracket is also taxed at 15%. This double taxation results in a 30% marginal tax rate before the 25% bracket starts.

It is important to understand this double taxation concept before looking at the green line that represents the marginal tax brackets that you will face while receiving your Social Security Benefits. Your benefits are also tax deferred. The dotted red line shows where your benefits become 50% taxable and then 85% taxable. The dotted green line shows the normal federal brackets.

Note that the first retirement marginal tax bracket is 15%. You are already in the 50% Social Security taxability bracket when the normal 10% bracket starts so you are paying 10% of each dollar of taxable income plus 10% of the 50 cents of Social Security that that dollar made taxable. You are again being double taxed on the new dollar of income plus the deferred Social Security benefit that that dollar made taxable.

There is a section of green line at the 27.75% marginal bracket which is 185% of the normal 15% tax bracket. The small 55.5% marginal bracket is actually double taxation of your double taxation. It is 15% on the actual dollars earned plus 15% on your gains and dividend, and all of that times 185% due to the taxable Social Security level. The 46.25% marginal bracket is 185% of the normal 25% tax bracket which ends when 85% of your total Social Security benefit has been taxed. At that point the double taxation stops and you go back to the standard 25% tax bracket.

Median Viewpoint
When your Social Security Benefits and other taxable income places you in section A of this graph you are primarily looking for ways to avoid paying any taxes. When you are in section D you are looking in the rear view mirror at the fact that 15% of your Social Security Benefits were tax free and you paid a lower rate on your capital gains and dividends.

This page is designed to look at sections B and C of the graph. These sections are generally faced by those earning slightly above the current median income level of $50,000 but not yet into the six figure category, this represents a fairly substantial percentage of the population. What can you do to avoid paying the 55.5% and 46.25% marginal tax bracket?

So, let’s take a look at some taxation examples:



These graphs illustrate a few very important points:
 * 1) Look at the “Tax Rate” columns: The taxability of your Social Security benefits occurs earlier for married couples which creates a marriage penalty for median income individuals.
 * 2) All of the marginal tax bracket lines are different: Your personal graph probably does not look the same as anyone you know.
 * 3) As your Social Security benefit increases:
 * 4) *The income where you start paying taxes increases, you save more tax dollars.
 * 5) *The size of your personal 46.25% tax hump increases, the IRS wants more back.
 * 6) The colors of the required gross income tick marks for the same after tax standard of living is in the reverse order from the start taxation lines. You are replacing less tax deferred income with taxable income.

Retire Early
Whenever you attend one of those free dinner financial meetings they are always telling you that if you wait until 70 to start your Social Security benefits it will take you 9 or 10 years to catch up on the amount you would have if you started your benefits at age 62.

This is a true statement, but it is not an accurate statement. If you only look at the SS Benefit column in the Single $60,000 example above, the math does work out to a 9 to 10 year catch period. The problem is that the lower tax deferred SS Benefit requires a larger taxable withdrawal from your IRA which requires you to pay a much higher tax rate than if you waited until 70 to get more tax deferred income and less taxable income.

The table to the right uses SS Benefit minus Taxes Paid for its calculations so the catch period is only 5 to 6 years. By year 11 you will have received almost $100,000 more in after tax benefits!

Remember to look at all of the aspects of your retirement planning, not just what a salesman is trying to tell you.

Standard of Living


These are average SS Benefit graphs based on earning an inflation adjusted average income of $60,000 when you retire at 62, 66, and 70. The tick marks in the left graph illustrate your gross income when you plan your retirement at 80% of your pre-retirement income and the right graph illustrates 90%.

Note how increasing your standard of living requires more ordinary (taxable) income which increases your tax rate. Also note that the tick marks at 80% are all below their related 46.25% marginal tax rates while the green tick is beyond that rate and the blue tick is barely starting the 46.25% rate when living on 90%.

Inflation


Using today’s retirement income of $30,000 SSB plus $27,000 from taxable sources line IRA/401K withdrawals, pensions, annuities, etc. plus $6,000 of capital gains, we can adjust those income by the inflation factors for 1983 when the 50% taxability bracket was created, 1993 when the 85% taxability bracket was create, today, and what it will look like when a compound 25% COLA increase occurs.

The taxability points were set in 1983 and 1993 at $25,000 and $34,000 for single individuals and $32,000 and $44,000 for married couples. These taxability points are not COLA adjusted so they are the same now as they were 23 and 33 years ago. As a result inflation is making larger percentages of our benefits taxable each year which pushes us into higher marginal tax bracket.

But, if you do see a potential problem, what can you do?

Pay off Mortgage
We saw an example of what happens when we increase our income to increase our standard of living. What if we could reduce our income by eliminating our mortgage payment?

If your personal situation makes this profitable, instead of putting extra money in your 401K saving your current 25% tax bracket and later withdrawing that money at 46.25% to make a mortgage payment, put that extra money into a Roth account after paying the 25% tax so you can withdraw it at 0% later to pay the mortgage.

Roth Conversions
Instead of contributing $6,500 to your Roth account, what is you used that money to pay the taxes for a Roth Conversion? You could move/convert $21,225 of your standard IRA to Roth which, depending on your State, would cause a 7.5% state tax of $1,592 which would be deductible making your federal taxable income $19,633 and result in a federal tax of $4,908. In other words, your $6,500 Roth “contribution” could be enough to cover a full year of mortgage payments.

There are many things that you should consider when thinking about a Roth Conversion. Paying 25% federal tax while working does save you a small amount over paying a 27.75% marginal rate while retired, but not if you are now working in a high tax state and retire in a low tax state. Paying 25% or 28% now to avoid 46.25% later is probably a good idea even if you do move to a low tax state.

Medicare Part B
Beware of the hidden “taxes” if you decide to do Roth Conversions after starting your Social Security and Medicare benefits. Your 2016 taxes will be processed in 2017. Your MAGI, Modified Adjusted Gross Income (see Medicare site for the modifications), will then be used to determine your Medicare Part B rates for 2018.

Here are the Part B premiums for 2016. Note that if your MAGI goes over $85,000 your annual Part B cost will increase by $584.40 and if it crosses $107,000 it will increase another $877.20.



Recharacterization
It is possible to “recharacterize”, undo, a Roth Conversion before you pay the taxes!

Let’s assume that you can afford to convert $42,000 of your IRA to Roth and stay within the $85,000 MAGI. Throughout the year you take advantage of a few market corrections and do conversion of $70,000. The key here is that you opened separate Roth accounts at your broker for each market symbol that you converted.

You follow the value of each individual new Roth account through out the year and at some point, probably December but it could be later, you list the Rates of Return on each conversion. For any that have lost money since the conversion, you contact your broker or fill out the proper on-line forms to recharacterize, undo, that individual conversion as if it never happened. After all if you are going to lose money you should do that in the taxable IRA, not the tax free Roth.

Since you also have to reduce your MAGI to $85,000 you look at your list and also recharacterize the ones with the lowest RORs. You can also work with your broker to recharacterize a portion of the symbol that crosses over the $85,000 line.

Inheritance
There are currently 15 states and D.C. that have estate taxes. Most estate taxes are relatively high percentage on inheritances over a million dollars. This page talks about Median income individuals, so we can skip that.

There are also 6 states that have an inheritance tax. In Maryland for example you have to pay 10% on everything over $1,000.

This could be another reason for a Roth Conversion. If you leave a $300,000 IRA to someone in Maryland they will owe $30,000 in taxes which they might have to take out of a taxable source. At 33.33% total state and federal taxes, they would have to withdraw $45,000 to pay the taxes. If you have converted the $300,000 IRA to Roth at 33.33% the Roth would be worth $200,000 and they would only owe $20,000 in taxes for which they now have a non-taxable source for the needed $20,000.

Conclusion
The information that I get from the financial advisors that I have talked to is that running the tax numbers and planning the best approach for a median income individual takes about the same amount of time as someone making double that amount. Therefore, the necessary billing would not be cost effective for a median income individual.

It is extremely important for individuals who will eventually face these tax situations to get a picture of their personal tax brackets and where their personal desired standard of living will place them in relation to those brackets.