Joe and Mary were looking forward to a life of travel and golf. They’d retire with $40,000 in tax-free Social Security benefits, and supplement it with $55,000 they planned to draw from their former 401k’s – now IRAs.
Sure there’d be $10,000 in taxes on the IRA withdrawals – but at $85,000 net, they’d still live pretty high on the hog.
Unfortunately, it’s wasn’t that simple. You see, when earnings from all other sources (like IRAs) exceeds $25,000 ($34,000 married), 50% of social security income becomes income taxable. And at $32,000 ($44,000 married), 85% of social security income is taxed.
Taxed at what rate? At the rate applied to the combined income, meaning a rate that might be higher than what would have been applied to “other” income alone.
That’s exactly what happened to Joe and Mary. Instead $10,000 of income tax on the IRA distributions, they’d pay $22,000 after adding 85% of their social security to their taxable total.
That meant $12,000 a year less to live on than they were counting on –$1,000/month. So much for the travel and golf. It was essentially a $12,000 hidden tax on their 401k/IRA that no one had ever told them about.
Sure – they could put one over on Uncle Sam by not taking distributions from the IRA’s … for a while… if living on $40,000 of Social Security alone would let them whoop it up to their heart’s content. But at age 70-1/2, Required Minimum (IRA) Distributions kick in – and Joe and Mary will be forced to take money out of the IRAs, and pay the hidden 401k tax for the rest of their lives.
Wouldn’t a tax-free alternative to the 401k/IRA be a better deal? “Comment” back if you want to know where to get that deal.
Awesome blog. I enjoyed reading your articles. This is truly a great read for me. I have bookmarked it and I am looking forward to reading new articles. Keep up the good work.
Great insight. If you wait until age to collect social security, will you still be affected?
Unfortunately – yes. Taxation of Social Security has nothing to do with the age when benefits are turned on – and everything to do with the fact that it is counted as income when filing your tax return. Social Security isn’t taxable until your combined total income (including Social Security) exceeds a certain threshold (different for single vs. married). If it does however, either 50% – or 85% of your social security benefits will be taxed at the same rate as all your other income – both federally and at the state level.
Considering Social Security is taken from your paycheck as a tax – then taxed again when paid back – it doesn’t seem fair…something about double taxation. However – those are the rules, which is why I help clients receive their “other income” from tax-free sources. Tax-free is good by itself – but great when it protects Social Security income from taxation too!