Posts
Hi Readers!
I'm on vacation!
I'll be back with new blog posts at the end of May.
Friday, May 15, 2009
Thursday, May 14, 2009
The Social Security Trust Fund
On Tuesday, the trustees of the Social Security Trust Fund issued their annual report. It’s getting bleak; like our 401(k) statements.
Of all the key projections, the keyest projection of all is the year the retirement Trust Fund is expected to run bone dry. That is now projected to happen in 2037, a full four years earlier than last year’s projection. That’s a big change. And it’s as much a testament to the fragility of long-term projections as it is to the fragility of the Fund.
What happens when the well runs dry? Revenues are then still pouring into the Fund—remember all those FICA taxes you’re paying—but they will be insufficient to pay 100% of promised benefits. In fact, they’re projected to be enough to pay only 76% of promised benefits. Unless, the law is changed, that’s all retirees will get: 76%. Some promise, huh!
Another key date that’s deteriorating is the year the Fund stops growing. Taxes and interest grow the Trust Fund, building up a needed surplus to deal with a substantial projected increase in promised benefits. The Fund is projected to switch from growth to erosion in 2016, one year earlier than last year’s projection.
There’s lots of reasons for this deterioration—greater unemployment, slower growth in wages, low interest income on the Treasury bonds comprising Trust Fund’s assets. But at least the Trust Fund hasn’t been decimated by last year’s poor stock market performance. There ain’t no stocks in the Fund.
Clearly all our political leaders need to agree to resolve the solvency of the Trust Fund. Even if the solution ultimately favored by the majority is not their favorite solution, at least they should agree that some early action is better than inaction. It is manifestly unfair for future retirees to see their “promised” benefits shaved when they (we) have been cheerfully—or at least dutifully—supporting current retirees with our payroll taxes.
What are your favorite solutions to the actuarial shortfall? I've previously bloviated as to my own favorite fix, in January 11's post. I've shown you mine; you show me yours.
Of all the key projections, the keyest projection of all is the year the retirement Trust Fund is expected to run bone dry. That is now projected to happen in 2037, a full four years earlier than last year’s projection. That’s a big change. And it’s as much a testament to the fragility of long-term projections as it is to the fragility of the Fund.
What happens when the well runs dry? Revenues are then still pouring into the Fund—remember all those FICA taxes you’re paying—but they will be insufficient to pay 100% of promised benefits. In fact, they’re projected to be enough to pay only 76% of promised benefits. Unless, the law is changed, that’s all retirees will get: 76%. Some promise, huh!
Another key date that’s deteriorating is the year the Fund stops growing. Taxes and interest grow the Trust Fund, building up a needed surplus to deal with a substantial projected increase in promised benefits. The Fund is projected to switch from growth to erosion in 2016, one year earlier than last year’s projection.
There’s lots of reasons for this deterioration—greater unemployment, slower growth in wages, low interest income on the Treasury bonds comprising Trust Fund’s assets. But at least the Trust Fund hasn’t been decimated by last year’s poor stock market performance. There ain’t no stocks in the Fund.
Clearly all our political leaders need to agree to resolve the solvency of the Trust Fund. Even if the solution ultimately favored by the majority is not their favorite solution, at least they should agree that some early action is better than inaction. It is manifestly unfair for future retirees to see their “promised” benefits shaved when they (we) have been cheerfully—or at least dutifully—supporting current retirees with our payroll taxes.
What are your favorite solutions to the actuarial shortfall? I've previously bloviated as to my own favorite fix, in January 11's post. I've shown you mine; you show me yours.
Wednesday, May 13, 2009
Magnitude/Likelihood Matrix of Real Returns
May 11’s post and May 12’s post described extreme results—the worst and the best—for stocks and bonds over three different time frames. But hidden within the charts in May 11’s post is a third facet of risk and uncertainty: It’s an entire matrix of possible outcomes ranked by magnitude and likelihood.
You can—and should—use bad extremes to eliminate investment and spending plans with outcomes you just couldn’t stand. (Or should I say “investment-spending plans,” the way physicists say “space-time,” since the two are so intimately linked.) But then you’re (hopefully) left with a range of remaining choices. It helps to have a sense of (a) just how good (or bad) an outcome might be, and (b) the likelihood of that size outcome.
One way to get a sense of life’s magnitude/likelihood matrix is to look at historical percentiles. You surely remember percentiles from when you took the SATs. For example, in the numbers below, the 30th percentile real return is 8.6%. That means 8.6% is the aggregate real return that is better than 30% of all the outcomes studied. Looked at another way, you stand a kinda’ sorta’ 70% likelihood of realizing an 8.6% or greater real return; and a 30% kinda’ sorta’ likelihood of realizing less than 8.6% aggregate real return. You gotta’ be real lucky to experience a 90th percentile future; and real unlucky to experience a 10th percentile future.
With that as background, and by way of example, here’s the magnitude/likelihood matrix for aggregate real returns on a portfolio with a 50%-50% mixture of stocks and bonds over 60-month periods between 1926 and 2008.
90th percentile: 67.8%
80th percentile: 55.5%
70th percentile: 44.2%
60th percentile: 36.1%
50th percentile: 27.7%
40th percentile: 19.0%
30th percentile: 8.6%
20th percentile: 1.4%
10th percentile: -5.1%
Two caveats:
1. Don’t get fooled into thinking these percentiles tell you the probability of future outcomes. They’re only "kinda’ sorta’" probabilities. You can’t use the past to predict the future; but you can use it as a tool to help you plan in the face of uncertainty.
2. The foregoing figures represent the aggregate five-year growth (or shrinkage) in the real (inflation-adjusted) size of a pot of assets. As pointed out in yesterday’s post, that’s not really the right yardstick. Ultimately, your allowance is the right yardstick when planning your retirement. I chose this particular measurement because it’s an easy one to measure, and it’s useful in illustrating the concept of a magnitude/likelihood matrix.
You can—and should—use bad extremes to eliminate investment and spending plans with outcomes you just couldn’t stand. (Or should I say “investment-spending plans,” the way physicists say “space-time,” since the two are so intimately linked.) But then you’re (hopefully) left with a range of remaining choices. It helps to have a sense of (a) just how good (or bad) an outcome might be, and (b) the likelihood of that size outcome.
One way to get a sense of life’s magnitude/likelihood matrix is to look at historical percentiles. You surely remember percentiles from when you took the SATs. For example, in the numbers below, the 30th percentile real return is 8.6%. That means 8.6% is the aggregate real return that is better than 30% of all the outcomes studied. Looked at another way, you stand a kinda’ sorta’ 70% likelihood of realizing an 8.6% or greater real return; and a 30% kinda’ sorta’ likelihood of realizing less than 8.6% aggregate real return. You gotta’ be real lucky to experience a 90th percentile future; and real unlucky to experience a 10th percentile future.
With that as background, and by way of example, here’s the magnitude/likelihood matrix for aggregate real returns on a portfolio with a 50%-50% mixture of stocks and bonds over 60-month periods between 1926 and 2008.
90th percentile: 67.8%
80th percentile: 55.5%
70th percentile: 44.2%
60th percentile: 36.1%
50th percentile: 27.7%
40th percentile: 19.0%
30th percentile: 8.6%
20th percentile: 1.4%
10th percentile: -5.1%
Two caveats:
1. Don’t get fooled into thinking these percentiles tell you the probability of future outcomes. They’re only "kinda’ sorta’" probabilities. You can’t use the past to predict the future; but you can use it as a tool to help you plan in the face of uncertainty.
2. The foregoing figures represent the aggregate five-year growth (or shrinkage) in the real (inflation-adjusted) size of a pot of assets. As pointed out in yesterday’s post, that’s not really the right yardstick. Ultimately, your allowance is the right yardstick when planning your retirement. I chose this particular measurement because it’s an easy one to measure, and it’s useful in illustrating the concept of a magnitude/likelihood matrix.
Tuesday, May 12, 2009
Magnitude of 12-Month Real Gains
Yesterday’s post explored one facet of risk: The potential magnitude of real losses you would have experienced over different time frames in past years with your stock and bond investments. It pays to know the extremes of bad outcomes you might expect, as that can help you select an appropriate asset allocation; you can then eliminate asset allocations with potential outcomes you simply could not stand.
But why are you looking at just the worst outcomes? What are you, some kind of paranoid? What about the best outcomes? Take a look at the right hand extremes of the charts in yesterday’s post. These endpoints represent the best historical real returns of stocks, bonds, and a 50%-50% mixture over different time frames.
To summarize, here are the historically best aggregate real returns between 1926 and 2008:
Over 12 Months:
Stocks: 182%
Bonds: 26%
50%-50% mixture: 99%
Over 60 Months:
Stocks: 347%
Bonds: 105%
50%-50% mixture: 157%
Over 120 Months:
Stocks: 473%
Bonds: 146%
50%-50% mixture: 216%
Of course, you don’t plan your future by looking at the rosiest outcome. To the contrary. You plan by eliminating options that carry a meaningful likelihood of disastrous results. But it’s instructive to understand the other extreme as well.
Two important caveats: (1) Future outcomes can certainly be worse than any experienced in the past. (2) The growth and shrinkage of your pot of retirement assets is something of a red herring. The right yardstick is the growth and shrinkage of your future annual spending. While the size of your pot is an important key determinant, it’s just a step on the road to what really matters: Your standard of living as reflected in the allowance you allow yourself, given the size of the pot. More to come on this in future posts.
But why are you looking at just the worst outcomes? What are you, some kind of paranoid? What about the best outcomes? Take a look at the right hand extremes of the charts in yesterday’s post. These endpoints represent the best historical real returns of stocks, bonds, and a 50%-50% mixture over different time frames.
To summarize, here are the historically best aggregate real returns between 1926 and 2008:
Over 12 Months:
Stocks: 182%
Bonds: 26%
50%-50% mixture: 99%
Over 60 Months:
Stocks: 347%
Bonds: 105%
50%-50% mixture: 157%
Over 120 Months:
Stocks: 473%
Bonds: 146%
50%-50% mixture: 216%
Of course, you don’t plan your future by looking at the rosiest outcome. To the contrary. You plan by eliminating options that carry a meaningful likelihood of disastrous results. But it’s instructive to understand the other extreme as well.
Two important caveats: (1) Future outcomes can certainly be worse than any experienced in the past. (2) The growth and shrinkage of your pot of retirement assets is something of a red herring. The right yardstick is the growth and shrinkage of your future annual spending. While the size of your pot is an important key determinant, it’s just a step on the road to what really matters: Your standard of living as reflected in the allowance you allow yourself, given the size of the pot. More to come on this in future posts.
Monday, May 11, 2009
Magnitude of 12-Month Real Losses
May 7’s post explored how frequently your investments might be expected to experience real (i.e., inflation-adjusted) losses after different lengths of time. The graph in that post showed, historically, how frequently investments in stocks, bonds, and a 50%-50% mixture of stocks and bonds have exhibited real losses over periods ranging from 12 months to 52 years.
Pretty good information. It provides you with a gauge of how frequently you might get scared. But there’s another dimension to consider. Just how scared will you get? Are we talking “Ghostbusters” or “Alien”?
The charts below attempt to give an idea of the magnitude of the real losses (and gains) that the markets have historically provided. Rather than the frequency of bad results, it measures their size.
The bottom chart summarizes the results over short (12-month) periods. As might be expected, stocks have been very scary over the short run, exhibiting the worst potential losses over 12-month periods—as bad as a 64% loss in value. In contrast, bonds’ worst 12-month real loss has been only 16%. A 50%-50% mixture of stocks and bonds resulted in a 27% worst-historical-case loss. The range between worst cases and best cases are shown in 10-percentile increments. (As with May 7’s post, I looked at all 12-month periods between January 1, 1926 and December 31, 2008. There have been 977 of them. For stocks, I used total return on the S&P 500; for bonds, intermediate term Treasury bonds; and for inflation, changes in the Consumer Price Index. In other words, the usual suspects.)
If you lengthen the period between measurements, ignoring interim ups and downs, things start to change. The middle chart shows the same data for 60-month (5-year) periods. Stocks still exhibit the potentially worst result, with a worst-case real loss during 1926-2008 of up to 51%, with bonds’ worst real loss over a 60-month period of 28%. With time, stocks' worst performance gets better, and bonds' worst performance gets worse. And the 50%-50% mixture of stocks and bonds now exhibits the best worst case, with only a 21% loss.
And if you lengthen it further to 120 months (10 years), the pattern continues to hold: A 50%-50% mixture of stocks and bonds has provided the least bad worst case, as shown in the top chart below.
By the way, those of us who suffered through 2008 will not be surprised to learn that between 1926 and 2008, the worst 120-month period for stocks, in terms of inflation-adjusted losses, was the 120 months from December 1, 1998 to November 30, 2008. Just thought you might want to know.
Pretty good information. It provides you with a gauge of how frequently you might get scared. But there’s another dimension to consider. Just how scared will you get? Are we talking “Ghostbusters” or “Alien”?
The charts below attempt to give an idea of the magnitude of the real losses (and gains) that the markets have historically provided. Rather than the frequency of bad results, it measures their size.
The bottom chart summarizes the results over short (12-month) periods. As might be expected, stocks have been very scary over the short run, exhibiting the worst potential losses over 12-month periods—as bad as a 64% loss in value. In contrast, bonds’ worst 12-month real loss has been only 16%. A 50%-50% mixture of stocks and bonds resulted in a 27% worst-historical-case loss. The range between worst cases and best cases are shown in 10-percentile increments. (As with May 7’s post, I looked at all 12-month periods between January 1, 1926 and December 31, 2008. There have been 977 of them. For stocks, I used total return on the S&P 500; for bonds, intermediate term Treasury bonds; and for inflation, changes in the Consumer Price Index. In other words, the usual suspects.)
If you lengthen the period between measurements, ignoring interim ups and downs, things start to change. The middle chart shows the same data for 60-month (5-year) periods. Stocks still exhibit the potentially worst result, with a worst-case real loss during 1926-2008 of up to 51%, with bonds’ worst real loss over a 60-month period of 28%. With time, stocks' worst performance gets better, and bonds' worst performance gets worse. And the 50%-50% mixture of stocks and bonds now exhibits the best worst case, with only a 21% loss.
And if you lengthen it further to 120 months (10 years), the pattern continues to hold: A 50%-50% mixture of stocks and bonds has provided the least bad worst case, as shown in the top chart below.
By the way, those of us who suffered through 2008 will not be surprised to learn that between 1926 and 2008, the worst 120-month period for stocks, in terms of inflation-adjusted losses, was the 120 months from December 1, 1998 to November 30, 2008. Just thought you might want to know.
Sunday, May 10, 2009
Annuities I’d Like to See
Yesterday’s post discussed the three main functions of that pot of assets you’ve accumulated toward your retirement. Since the mainest of the main functions is to provide you with a stream of retirement income for the rest of your indeterminate life, the purchase of an annuity with some of those assets theoretically serves that function quite well. Emphasis on the word “theoretically.” If only the absolute right insurance product existed! If anyone out there knows of a product that meets all of the following criteria, please post a comment or send me an email. And pass this post on to your insurance agent to get some additional professional perspective.
Longevity Insurance. According to some academics, the most efficient use of your hard-earned assets would be to use a small portion of them (I’ve seen estimates of 10% to 15%) to purchase an annuity that doesn’t start to pay you unless and until you reach an advanced age. Say 85. So the annuity is really a form of insurance. Longevity insurance. Some insurance companies, but not too many, offer annuities of this sort.
Buying a pure annuity requires a trade-off. You lose emergency access to the funds, and you eliminate your children’s inheritance. But you get something valuable in exchange: Every dollar goes toward providing you a lifetime allowance. So using only 10%-15% of your assets for this purpose sounds like a pretty good trade-off .
Inflation Adjustment. The ideal annuity/longevity insurance would have inflation protection by increasing annual payments by changes in the Consumer Price Index. Such a product exists (one is offered by AIG) in the world of immediate annuities, but not in the world of longevity insurance where payout is deferred 20 years or so. That would be nice to have.
Low Creditor Risk. Speaking of AIG, you want to buy an annuity only from a company that is superbly solvency. You’ll be relying on that solvency for a long long time. All states offer a guaranty fund in case an insurer goes belly up, but only up to stated limits which differ from state to state, and which may not cover your entire annuity.
Rate Risk. The annuity you’re able to buy will vary, largely with current interest rates, depending on when you buy it. For example, an article by Chen and Malevsky point out that $100,000 would have purchased a $1,150/month annuity in the 1980’s, but only about $700/month in 2003. That’s a 36% drop, just depending on what year you bought the thing. An ideal annuity product would allow you to buy a little slice of your longevity insurance each year during your working years—and beyond—in order to hedge against this fluctuating market.
Transparency. It’s hard to know whether you’re getting a good deal from your insurer. It would be nice if there was some uniform basis on which to compare similar, but not identical, products from different insurers.
If there were products meeting these criteria, maybe that would solve the "annuity puzzle," as it's been called: The mystery of why more people don't buy these things.
Any annuity you purchase ought to then have an impact on how you invest and spend the balance of your assets. Indeed, the same statement applies to your Social Security benefit and any pension you’ve earned. The existence of these largely-guaranteed streams of income can free you up for greater spending and a higher percentage of riskier higher-yielding investments.
All credit for some of the good ideas expressed in this post goes to discussions with my friends Peter (of Stembrook Asset Management) and Jennifer. All of the bad ideas, of course, are mine.
Longevity Insurance. According to some academics, the most efficient use of your hard-earned assets would be to use a small portion of them (I’ve seen estimates of 10% to 15%) to purchase an annuity that doesn’t start to pay you unless and until you reach an advanced age. Say 85. So the annuity is really a form of insurance. Longevity insurance. Some insurance companies, but not too many, offer annuities of this sort.
Buying a pure annuity requires a trade-off. You lose emergency access to the funds, and you eliminate your children’s inheritance. But you get something valuable in exchange: Every dollar goes toward providing you a lifetime allowance. So using only 10%-15% of your assets for this purpose sounds like a pretty good trade-off .
Inflation Adjustment. The ideal annuity/longevity insurance would have inflation protection by increasing annual payments by changes in the Consumer Price Index. Such a product exists (one is offered by AIG) in the world of immediate annuities, but not in the world of longevity insurance where payout is deferred 20 years or so. That would be nice to have.
Low Creditor Risk. Speaking of AIG, you want to buy an annuity only from a company that is superbly solvency. You’ll be relying on that solvency for a long long time. All states offer a guaranty fund in case an insurer goes belly up, but only up to stated limits which differ from state to state, and which may not cover your entire annuity.
Rate Risk. The annuity you’re able to buy will vary, largely with current interest rates, depending on when you buy it. For example, an article by Chen and Malevsky point out that $100,000 would have purchased a $1,150/month annuity in the 1980’s, but only about $700/month in 2003. That’s a 36% drop, just depending on what year you bought the thing. An ideal annuity product would allow you to buy a little slice of your longevity insurance each year during your working years—and beyond—in order to hedge against this fluctuating market.
Transparency. It’s hard to know whether you’re getting a good deal from your insurer. It would be nice if there was some uniform basis on which to compare similar, but not identical, products from different insurers.
If there were products meeting these criteria, maybe that would solve the "annuity puzzle," as it's been called: The mystery of why more people don't buy these things.
Any annuity you purchase ought to then have an impact on how you invest and spend the balance of your assets. Indeed, the same statement applies to your Social Security benefit and any pension you’ve earned. The existence of these largely-guaranteed streams of income can free you up for greater spending and a higher percentage of riskier higher-yielding investments.
All credit for some of the good ideas expressed in this post goes to discussions with my friends Peter (of Stembrook Asset Management) and Jennifer. All of the bad ideas, of course, are mine.
Saturday, May 9, 2009
Three Functions of Retirement Savings
OK. So you’ve built up this nice big pot of assets on which to retire. As you embark on the difficult quest of adopting a retirement spending plan—your scheme for determining how much you’re going to allow yourself to spend each year—your allowance, as it were—it’s helpful to consider the three main functions of that cache. Here they are in order of importance, at least for most people:
1. A source for your annual retirement spending. Duh.
2. A reserve for unanticipated emergencies.
3. An inheritance for your heirs, usually your kids.
Let me dwell on these functions in reverse order.
Inheritance. Not so important for most people. You’re struggling just to maintain your own lifestyle, so how can you give any weight to luxuries for the next generation? So function #3 is strictly on the back burner. But two points are worth noting.
First, at some point, if the pot is large enough, the marginal utility of spending another dollar on your standard of living is just not enough to outweigh the pleasure you’d get from leaving—or giving—something to your kids. Maybe you’d rather help them make a down payment on their first house than buy yourself that pearl-handled backscratcher you admired in the window at Tiffany’s.
Second, as discussed in March 20’s post, leaving an inheritance is an inevitable, if unintended, by-product of not knowing how long you and your spouse are going to live.
Emergency Reserve. Stuff happens. You plan to spend your assets roughly equally each year, but then the roof springs a leak. Or Bowser contracts canine chilblains. Whatever. Even if you do your financial planning perfectly, and your investments perform just as you project (which they won’t; I’m just making a point here) life will hit you with your own personalized pig bladder. So you need to keep a reserve for the inevitable unexpected. (Is it correct to call the inevitable “unexpected”? Probably not.)
Note, however, that your need for an emergency reserve shrinks with your shrinking life expectancy. One year older? That’s one less year of financial curveballs ahead of you.
Retirement Spending. The main function of that pot you’ve accumulated (the financial one; not the one hanging over your belt) is to provide a stream of spending for your indeterminate lifetime. While you don’t know how much you’re going to need for the future, you have a rough sense that it shrinks as you get older: fewer years left to spend on yourself; fewer years to get stung by crummy financial markets. So perhaps the percentage of assets that you spend should somehow—slowly and conservatively, but somehow—grow with the passing years. Maybe an 85-year old can prudently spend a bigger percentage of her assets than a newly superannuated 65-year old.
So those are the three main functions of your treasure trove. (What have I left out? Send me an email or post a comment.) Now the tricky part is to translate these generalizations into a scheme for spending your assets prudently. More to come on this—much more.
1. A source for your annual retirement spending. Duh.
2. A reserve for unanticipated emergencies.
3. An inheritance for your heirs, usually your kids.
Let me dwell on these functions in reverse order.
Inheritance. Not so important for most people. You’re struggling just to maintain your own lifestyle, so how can you give any weight to luxuries for the next generation? So function #3 is strictly on the back burner. But two points are worth noting.
First, at some point, if the pot is large enough, the marginal utility of spending another dollar on your standard of living is just not enough to outweigh the pleasure you’d get from leaving—or giving—something to your kids. Maybe you’d rather help them make a down payment on their first house than buy yourself that pearl-handled backscratcher you admired in the window at Tiffany’s.
Second, as discussed in March 20’s post, leaving an inheritance is an inevitable, if unintended, by-product of not knowing how long you and your spouse are going to live.
Emergency Reserve. Stuff happens. You plan to spend your assets roughly equally each year, but then the roof springs a leak. Or Bowser contracts canine chilblains. Whatever. Even if you do your financial planning perfectly, and your investments perform just as you project (which they won’t; I’m just making a point here) life will hit you with your own personalized pig bladder. So you need to keep a reserve for the inevitable unexpected. (Is it correct to call the inevitable “unexpected”? Probably not.)
Note, however, that your need for an emergency reserve shrinks with your shrinking life expectancy. One year older? That’s one less year of financial curveballs ahead of you.
Retirement Spending. The main function of that pot you’ve accumulated (the financial one; not the one hanging over your belt) is to provide a stream of spending for your indeterminate lifetime. While you don’t know how much you’re going to need for the future, you have a rough sense that it shrinks as you get older: fewer years left to spend on yourself; fewer years to get stung by crummy financial markets. So perhaps the percentage of assets that you spend should somehow—slowly and conservatively, but somehow—grow with the passing years. Maybe an 85-year old can prudently spend a bigger percentage of her assets than a newly superannuated 65-year old.
So those are the three main functions of your treasure trove. (What have I left out? Send me an email or post a comment.) Now the tricky part is to translate these generalizations into a scheme for spending your assets prudently. More to come on this—much more.
Friday, May 8, 2009
Timing of Roth Conversion
In a comment to May 4’s post, “Financial Planner Atlanta” (if that’s your real name) raised a good question. How does the timing of a 2010 distribution from a 401(k) plan and follow-up IRA rollover affect the decision to convert a traditional Individual Retirement Account to a Roth IRA?
The fortunate answer is that the timing of the rollover is irrelevant to the tax cost of converting a pre-existing IRA to a Roth IRA.
Let’s say the IRA is worth $200,000 and the 401(k) is worth $1,000,000. By rolling over the $1,000,000 to a traditional IRA, that $1,000,000 is excluded from your Adjusted Gross Income and from your taxable income. So when you add the $100,000 IRA balance to your other 2010 income to figure your tax cost, the $1,000,000 doesn’t appear anywhere or affect any of your tax calculations.
And the same is true if you elect to have the $200,000 taxed in 2011 and 2012, $100,000 each year. The $1,000,000 rollover disappears from those tax calculations as well.
And the same is true whether the 401(k) rollover occurs before or after the Roth IRA conversion. Or even if the Roth IRA conversion happens during the up-to-60-day period between when the 401(k) plan distributes the $1,000,000 and you roll it into your IRA.
Finally, once the dust settles on the rollover, you have th rest of the year to decide if you want to Rothificate some of it in addition to the original $200,000. At a greater tax cost, of course.
I hope that answers the question.
The fortunate answer is that the timing of the rollover is irrelevant to the tax cost of converting a pre-existing IRA to a Roth IRA.
Let’s say the IRA is worth $200,000 and the 401(k) is worth $1,000,000. By rolling over the $1,000,000 to a traditional IRA, that $1,000,000 is excluded from your Adjusted Gross Income and from your taxable income. So when you add the $100,000 IRA balance to your other 2010 income to figure your tax cost, the $1,000,000 doesn’t appear anywhere or affect any of your tax calculations.
And the same is true if you elect to have the $200,000 taxed in 2011 and 2012, $100,000 each year. The $1,000,000 rollover disappears from those tax calculations as well.
And the same is true whether the 401(k) rollover occurs before or after the Roth IRA conversion. Or even if the Roth IRA conversion happens during the up-to-60-day period between when the 401(k) plan distributes the $1,000,000 and you roll it into your IRA.
Finally, once the dust settles on the rollover, you have th rest of the year to decide if you want to Rothificate some of it in addition to the original $200,000. At a greater tax cost, of course.
I hope that answers the question.
Thursday, May 7, 2009
Frequency of 12-Month Real Losses
April 28’s post and yesterday’s post explored the frequency with which your investment accounts might be expected to show real, inflation-adjusted losses. Let’s look at that from just one more perspective.
April 28’s post looked at calendar year periods of different lengths. But we can get a more robust sense of how long it might take for different asset classes to recover from real losses by looking at 12-month periods of all sorts—not just calendar years. After all, there have only been 83 calendar years between 1926 and 2008—the period studied—but there have been 988 12-month periods to pore over if we look at all 12-calendar-month periods (e.g., April 1 2008 – March 31, 2009) between January 1, 1926 and March 31, 2009.
The pattern we saw in April 28’s post holds. Take a look at the graph below. Historically, both stocks and bonds have recovered from real (i.e., inflation-adjusted) losses given enough time. The longer the period between measurements, the less likely your investment will have experienced a real loss. Stocks (the blue line) have taken as long as 19 12-month periods, and bonds (the red line) have taken as long as 52 12-month periods. A 50%-50% mixture of stocks and bonds (the green line) has taken up to 20 12-month periods, but overall has tended to suffer fewer losing periods than either stocks or bonds standing alone.
As in prior posts, I measured stock performance by the total return on the S&P 500; bond returns by the total return on intermediate term Treasury bonds; and inflation by changes in the consumer price index.
As previously pointed out, this is just one aspect of investment risk, and a rather narrow one at that. Stay tuned for more and different ways to wallow around in risk.
April 28’s post looked at calendar year periods of different lengths. But we can get a more robust sense of how long it might take for different asset classes to recover from real losses by looking at 12-month periods of all sorts—not just calendar years. After all, there have only been 83 calendar years between 1926 and 2008—the period studied—but there have been 988 12-month periods to pore over if we look at all 12-calendar-month periods (e.g., April 1 2008 – March 31, 2009) between January 1, 1926 and March 31, 2009.
The pattern we saw in April 28’s post holds. Take a look at the graph below. Historically, both stocks and bonds have recovered from real (i.e., inflation-adjusted) losses given enough time. The longer the period between measurements, the less likely your investment will have experienced a real loss. Stocks (the blue line) have taken as long as 19 12-month periods, and bonds (the red line) have taken as long as 52 12-month periods. A 50%-50% mixture of stocks and bonds (the green line) has taken up to 20 12-month periods, but overall has tended to suffer fewer losing periods than either stocks or bonds standing alone.
As in prior posts, I measured stock performance by the total return on the S&P 500; bond returns by the total return on intermediate term Treasury bonds; and inflation by changes in the consumer price index.
As previously pointed out, this is just one aspect of investment risk, and a rather narrow one at that. Stay tuned for more and different ways to wallow around in risk.
Wednesday, May 6, 2009
Frequency of Monthly Real Losses
April 26’s post explored the frequency with which your investment accounts can be expected to show real, inflation-adjusted losses. And the clear pattern was this: Look at your account annually, and it’s scary; losses are depressingly frequent. Stretch out your interval between measurements, and losses tend to melt away. Time—if you’ve got it—heals all losses.
What if you go in the other direction? What if you measure the progress of your investment account more frequently, rather than less? After all, who can resist reviewing their accounts frequently? As indeed you should.
Not surprisingly, it turns out the pattern holds when you shorten the interval to a month. The frequency with which investments have incurred monthly real losses is a bit greater than the frequency of annual real losses. Here are the results for the 999 months between January 1926 and March 2009. Stocks have suffered a real loss in value 41% of the time (compared to 33% calendar year losses). Bonds have suffered a real loss 44% of the time (compared to 39% calendar year losses). And a 50%-50% mixture of stocks and bonds has suffered a real loss 41% of the time (compared to 31% calendar year losses).
As in April 26’s post, stock performance is measured by the total return on the S&P 500, including appreciation, depreciation and dividends. Bond performance is measured by the total return on intermediate term Treasury bonds. And inflation is measured by changes in the consumer price index.
So what’s the message? Quoting the great philosopher, Betty Davis in “All About Eve”: “Fasten your seatbelts. It’s going to be a bumpy ride.”
What if you go in the other direction? What if you measure the progress of your investment account more frequently, rather than less? After all, who can resist reviewing their accounts frequently? As indeed you should.
Not surprisingly, it turns out the pattern holds when you shorten the interval to a month. The frequency with which investments have incurred monthly real losses is a bit greater than the frequency of annual real losses. Here are the results for the 999 months between January 1926 and March 2009. Stocks have suffered a real loss in value 41% of the time (compared to 33% calendar year losses). Bonds have suffered a real loss 44% of the time (compared to 39% calendar year losses). And a 50%-50% mixture of stocks and bonds has suffered a real loss 41% of the time (compared to 31% calendar year losses).
As in April 26’s post, stock performance is measured by the total return on the S&P 500, including appreciation, depreciation and dividends. Bond performance is measured by the total return on intermediate term Treasury bonds. And inflation is measured by changes in the consumer price index.
So what’s the message? Quoting the great philosopher, Betty Davis in “All About Eve”: “Fasten your seatbelts. It’s going to be a bumpy ride.”
Tuesday, May 5, 2009
State Taxation of Retirement Distributions
How will your state tax your retirement distributions? That’s a cost which you will need to take into account as you set your savings goal.
Most states have their own income tax. A few states, like Florida, have no income tax. (What fuels their government? Sunshine? ) Of the states that do impose an income tax, many have chosen the expedient scheme of piggy-backing onto the federal income tax system by starting the state tax calculation with the income and deduction figures from your federal tax return, and then adding and subtracting a few adjustments from there. So in these states, if a dollar of distribution from a retirement account is taxable for federal purposes, it will be equally taxable for state purposes, at least initially. And in these states, if—as with a well-timed Roth IRA distribution—it’s not taxable for federal income tax purposes, then it won’t be taxable for state income tax purposes either.
Some states have enacted a special benefit for their senior citizens. New York, for example, exempts up to $20,000 of otherwise taxable retirement income from state tax. Thank you, New York!
Imagine this scenario, which is not atypical. You work all your life in a high tax state, like New York or California. During all those years you are earning contributions to retirement accounts which are not being taxed. Some contributions are made by your employer, and some are made by you (think 401(k)). These contributions have gone into the Tax Time Machine, as described in January 29’s post. Then you retire to sunny Florida—which has no income tax—and you start taking distributions from these accounts. “Wait a minute,” says the state of California, “you earned those dollars when you were working here. We want to collect some of that tax revenue, no matter where you live. We’re coming to get you!”
Can California do that? No, they can’t. They tried to, a number of years ago, and in response Congress passed a law making it illegal for a state to tax retirement plan distributions to residents of another state, even if the non-resident had earned the contributions while living and working in the taxing state. This law applies to tax-favored retirement accounts, like IRA’s and 401(k)’s, but it doesn’t apply to many non-qualified deferred compensation plans.
(What’s a non-qualified deferred compensation plan? It’s a kind of retirement plan only available to highly paid employees. If you’ve got one, you know what it is.)
So as you do your planning, and project your tax costs, pay a bit of attention to your state’s taxing scheme.
Most states have their own income tax. A few states, like Florida, have no income tax. (What fuels their government? Sunshine? ) Of the states that do impose an income tax, many have chosen the expedient scheme of piggy-backing onto the federal income tax system by starting the state tax calculation with the income and deduction figures from your federal tax return, and then adding and subtracting a few adjustments from there. So in these states, if a dollar of distribution from a retirement account is taxable for federal purposes, it will be equally taxable for state purposes, at least initially. And in these states, if—as with a well-timed Roth IRA distribution—it’s not taxable for federal income tax purposes, then it won’t be taxable for state income tax purposes either.
Some states have enacted a special benefit for their senior citizens. New York, for example, exempts up to $20,000 of otherwise taxable retirement income from state tax. Thank you, New York!
Imagine this scenario, which is not atypical. You work all your life in a high tax state, like New York or California. During all those years you are earning contributions to retirement accounts which are not being taxed. Some contributions are made by your employer, and some are made by you (think 401(k)). These contributions have gone into the Tax Time Machine, as described in January 29’s post. Then you retire to sunny Florida—which has no income tax—and you start taking distributions from these accounts. “Wait a minute,” says the state of California, “you earned those dollars when you were working here. We want to collect some of that tax revenue, no matter where you live. We’re coming to get you!”
Can California do that? No, they can’t. They tried to, a number of years ago, and in response Congress passed a law making it illegal for a state to tax retirement plan distributions to residents of another state, even if the non-resident had earned the contributions while living and working in the taxing state. This law applies to tax-favored retirement accounts, like IRA’s and 401(k)’s, but it doesn’t apply to many non-qualified deferred compensation plans.
(What’s a non-qualified deferred compensation plan? It’s a kind of retirement plan only available to highly paid employees. If you’ve got one, you know what it is.)
So as you do your planning, and project your tax costs, pay a bit of attention to your state’s taxing scheme.
Monday, May 4, 2009
Your Own Retirement Goal
All rules of thumb are wrong.
For instance, you sometimes read that a reasonable retirement goal is to spend 85% of what you are spending during your working years. At least I think that’s the rule of thumb. Or maybe it’s that your retirement income should be 85% of what your income was during your working years. These are two different things.
Whatever. It really doesn’t matter what the rule of thumb is, because it doesn’t apply to you anyway. In a comment to April 27’s post, for example, David suggests that his expenses will actually increase during his retirement years. In his case, he expects to incur higher travel costs. If he follows a rule of thumb in setting a retirement saving goal, he may have to actually use his thumb for travel.
So it pays to set a retirement savings goal based on your own spending needs. And what are they? Well, you can start with what you’re spending today and think through appropriate adjustments. How do you know what you’re currently spending? You could look at that directly by combing through your checkbook for the last few years, but that might be pretty tedious. Perhaps it’s easier to get at that indirectly by looking at your income and subtracting out your savings.
Then you can think through all your categories of spending, and project whether they will change—up or down. Here are a few items that may change:
• Retirement savings. That’s one “expense” that goes away. No more 401(k) deferrals; no more IRA contributions.
• FICA taxes. These stop when you’re no longer working.
• Your mortgage. When will this be paid off? Perhaps it's a disappearing expense. Unless you’re one of those refinancing addicts who take out a home equity loan before each visit to the gas station.
• Health insurance. Maybe this will go up, if your employer is now subsidizing this cost but won’t after retirement. Or maybe it will go down if you expect to rely on Medicare.
• Food. Maybe you’re cooking for four now, but that will drop to two after the kids are grown. Or maybe you’ll then eat out more. Or maybe dining out will cost less as you come to enjoy those early bird specials.
• Commuting expense. Goes down. Way down.
• Clothing. The cost of business suits goes down. But then again, Bermuda shorts, floral shirts and white shoes can be expensive, too.
• Travel. It’s a conundrum. Just when you have the time for more travel, your financial resources get constrained. But you’re able to take advantage of last-minute deals on cruises to Mexico and such.
• Grandchildren. That’s a whole new category.
What did I miss?
For instance, you sometimes read that a reasonable retirement goal is to spend 85% of what you are spending during your working years. At least I think that’s the rule of thumb. Or maybe it’s that your retirement income should be 85% of what your income was during your working years. These are two different things.
Whatever. It really doesn’t matter what the rule of thumb is, because it doesn’t apply to you anyway. In a comment to April 27’s post, for example, David suggests that his expenses will actually increase during his retirement years. In his case, he expects to incur higher travel costs. If he follows a rule of thumb in setting a retirement saving goal, he may have to actually use his thumb for travel.
So it pays to set a retirement savings goal based on your own spending needs. And what are they? Well, you can start with what you’re spending today and think through appropriate adjustments. How do you know what you’re currently spending? You could look at that directly by combing through your checkbook for the last few years, but that might be pretty tedious. Perhaps it’s easier to get at that indirectly by looking at your income and subtracting out your savings.
Then you can think through all your categories of spending, and project whether they will change—up or down. Here are a few items that may change:
• Retirement savings. That’s one “expense” that goes away. No more 401(k) deferrals; no more IRA contributions.
• FICA taxes. These stop when you’re no longer working.
• Your mortgage. When will this be paid off? Perhaps it's a disappearing expense. Unless you’re one of those refinancing addicts who take out a home equity loan before each visit to the gas station.
• Health insurance. Maybe this will go up, if your employer is now subsidizing this cost but won’t after retirement. Or maybe it will go down if you expect to rely on Medicare.
• Food. Maybe you’re cooking for four now, but that will drop to two after the kids are grown. Or maybe you’ll then eat out more. Or maybe dining out will cost less as you come to enjoy those early bird specials.
• Commuting expense. Goes down. Way down.
• Clothing. The cost of business suits goes down. But then again, Bermuda shorts, floral shirts and white shoes can be expensive, too.
• Travel. It’s a conundrum. Just when you have the time for more travel, your financial resources get constrained. But you’re able to take advantage of last-minute deals on cruises to Mexico and such.
• Grandchildren. That’s a whole new category.
What did I miss?
Sunday, May 3, 2009
3% is Depressingly Small
In a comment to April 27’s post, David points out how depressingly small 3% is. It simply ain’t that much. If that’s all your savings can generate, it doesn’t sound like you’re in for a luxurious retirement. That’s the main reason I don’t care for the 4% Plan (or 3% Plan or 3.5% Plan). It’s too darn miserly.
First, let me recap. When you retire, you need a plan for determining how much of your assets you’re going to spend each year. The goal is to spend as luxuriously as possible, without imprudently risking running out of money before your ticket is punched. That’s your “Retirement Spending Plan.”
One such plan, often written about in the financial press, is the 4% Plan. Add up your assets on the day you retire, multiply by 4%, and that’s your allowance for the year. Then the following year, increase the dollar amount of your allowance by inflation. And so on, and so on. As pointed out in April 27's post, 4% is the “right” percentage for assets in a tax-favored retirement account. But then if it’s a traditional IRA or other pre-tax account, income taxes will shave your after-tax spending (the part you can actually enjoy) down to 3%. (Not so with Roth accounts.) And maybe the “right” percentage for taxable accounts is 3.5% rather than 4%. Either way, these numbers—and therefore your allowance—simply aren’t that big. They do depress one, don’t they.
What are you buying by limiting your first year withdrawal to a miserly 4%? Two things. One is the security that you will not likely run out of spending money during your lifetime. That aspect of retirement security is, in my view, well worth the price.
But you’re buying something else for which you are paying dearly; too dearly in my view. That is the ability not to have to ratchet down your lifestyle in years when the financial markets are unkind. (And in the course of a typical retirement, there will be such years.) The 4% Plan allows you, to a degree, to ignore short-term losses and simply keep spending according to plan. But if you have some fat in your lifestyle—expenses you can cut back if need be—you can use that flexibility to buy a more luxurious lifestyle. You just have to be willing to have your annual allowance float with the ups and downs of the financial markets, and therefore your retirement assets. Then you can increase that 4% to something closer to 6%. That’s a 50% pay increase! Moreover, that 6% can gradually get bigger and bigger as your life expectancy decreases. Life is grand!
But you can’t have it both ways. If you increase your payout percentage you have to give up on the certainty of a fixed allowance. You have to be willing to cut back on your discretionary expenses when Mr. Dow Jones tells you to. And 2008 taught us that Mr. Dow Jones can be very cruel indeed. Cutting back is easier said than done.
More on the 6% Plan in future posts.
First, let me recap. When you retire, you need a plan for determining how much of your assets you’re going to spend each year. The goal is to spend as luxuriously as possible, without imprudently risking running out of money before your ticket is punched. That’s your “Retirement Spending Plan.”
One such plan, often written about in the financial press, is the 4% Plan. Add up your assets on the day you retire, multiply by 4%, and that’s your allowance for the year. Then the following year, increase the dollar amount of your allowance by inflation. And so on, and so on. As pointed out in April 27's post, 4% is the “right” percentage for assets in a tax-favored retirement account. But then if it’s a traditional IRA or other pre-tax account, income taxes will shave your after-tax spending (the part you can actually enjoy) down to 3%. (Not so with Roth accounts.) And maybe the “right” percentage for taxable accounts is 3.5% rather than 4%. Either way, these numbers—and therefore your allowance—simply aren’t that big. They do depress one, don’t they.
What are you buying by limiting your first year withdrawal to a miserly 4%? Two things. One is the security that you will not likely run out of spending money during your lifetime. That aspect of retirement security is, in my view, well worth the price.
But you’re buying something else for which you are paying dearly; too dearly in my view. That is the ability not to have to ratchet down your lifestyle in years when the financial markets are unkind. (And in the course of a typical retirement, there will be such years.) The 4% Plan allows you, to a degree, to ignore short-term losses and simply keep spending according to plan. But if you have some fat in your lifestyle—expenses you can cut back if need be—you can use that flexibility to buy a more luxurious lifestyle. You just have to be willing to have your annual allowance float with the ups and downs of the financial markets, and therefore your retirement assets. Then you can increase that 4% to something closer to 6%. That’s a 50% pay increase! Moreover, that 6% can gradually get bigger and bigger as your life expectancy decreases. Life is grand!
But you can’t have it both ways. If you increase your payout percentage you have to give up on the certainty of a fixed allowance. You have to be willing to cut back on your discretionary expenses when Mr. Dow Jones tells you to. And 2008 taught us that Mr. Dow Jones can be very cruel indeed. Cutting back is easier said than done.
More on the 6% Plan in future posts.
Saturday, May 2, 2009
Predicting Income Tax Rates
Can anyone predict the future of our income tax rates? David raised that issue in a comment to April 27’s post. I guess the correct answer is, yes you can predict future income tax rates; just not accurately.
In that regard, income tax rates are just like any other unknown variable that affects your retirement planning. How will your investments perform? How long will you live? What will Polident cost? You make your best guess and project from there. Then you stress test. You change your assumptions to see how that affects your projections.
My crystal ball is just as cloudy as yours, but I expect income tax rates will have to rise to pay for new health care initiatives, the recent stimulus plan, the unrecovered costs of bailing out the financial system, and the rest of the $10 trillion national debt that has accumulated since 1791.
A good starting point for projecting future income tax rates is to look at President Obama’s proposal. Right now it’s a little short on detail, but one feature would increase the highest marginal tax rate from 35% to 39.6% for incomes over $250,000 (over $200,000 if single). It would also increase the long-term capital gains tax rate and dividend tax rate to 20% for the same taxpayers. The phase-out of personal exemptions and itemized deductions would be reinstated, effectively tacking on a hidden tax rate of about one percentage point to high income people’s nominal tax rate. And the tax benefit of itemized deductions would be capped at something like 28%.
An aside about that last potential change. It sure sounds like it’s going to add a huge amount of complexity to an already overly complex Tax Code. And how will it interact with the Alternative Minimum Tax? Under one scenario, people who live in high-tax states like New York and New Jersey, whose deductions are already wiped out by the Alternative Minimum Tax, might not be adversely affected by this new wrinkle. But residents of no-tax states like Florida and Texas will. Maybe Treasury Secretary Geithner, in his spare time, can think of a way to get a similar revenue impact without adding undue complexity. Perhaps just add a point or two to the highest tax bracket.
The likelihood of higher future tax rates really turbo-charges the idea of converting your IRA to a Roth IRA in 2010.
In that regard, income tax rates are just like any other unknown variable that affects your retirement planning. How will your investments perform? How long will you live? What will Polident cost? You make your best guess and project from there. Then you stress test. You change your assumptions to see how that affects your projections.
My crystal ball is just as cloudy as yours, but I expect income tax rates will have to rise to pay for new health care initiatives, the recent stimulus plan, the unrecovered costs of bailing out the financial system, and the rest of the $10 trillion national debt that has accumulated since 1791.
A good starting point for projecting future income tax rates is to look at President Obama’s proposal. Right now it’s a little short on detail, but one feature would increase the highest marginal tax rate from 35% to 39.6% for incomes over $250,000 (over $200,000 if single). It would also increase the long-term capital gains tax rate and dividend tax rate to 20% for the same taxpayers. The phase-out of personal exemptions and itemized deductions would be reinstated, effectively tacking on a hidden tax rate of about one percentage point to high income people’s nominal tax rate. And the tax benefit of itemized deductions would be capped at something like 28%.
An aside about that last potential change. It sure sounds like it’s going to add a huge amount of complexity to an already overly complex Tax Code. And how will it interact with the Alternative Minimum Tax? Under one scenario, people who live in high-tax states like New York and New Jersey, whose deductions are already wiped out by the Alternative Minimum Tax, might not be adversely affected by this new wrinkle. But residents of no-tax states like Florida and Texas will. Maybe Treasury Secretary Geithner, in his spare time, can think of a way to get a similar revenue impact without adding undue complexity. Perhaps just add a point or two to the highest tax bracket.
The likelihood of higher future tax rates really turbo-charges the idea of converting your IRA to a Roth IRA in 2010.
Friday, May 1, 2009
Taxation of Social Security Benefits
In a comment to April 27’s post, David raised a question about the taxation of social security benefits. Actually, David touched on a number of issues, for which I am grateful as it provides fodder for future blog posts. But for today, it’s Social Security.
When you start receiving Social Security benefits, are they subject to federal income tax? Not totally. Here’s the story.
For many years social security benefits were totally tax-free. That was a great deal, but it didn’t last. In the early 80’s, as part of an effort to ensure the long-term solvency of the Social Security system, Congress decided to subject part of your benefits to income taxation. (That worked well, didn’t it?) Someone in the government actually keeps track of this little slice of our income tax revenue, and transfers that amount from the general coffers into the Social Security trust fund. But that doesn’t affect us individually, so let’s move on.
When Congress resolved to tax Social Security benefits, they didn’t go all the way. The thinking was this. Part of your benefit is funded with your share of FICA taxes; you know, that’s the 6.2% tax on the first $106,800 (in 2009) of your salary. But you already paid income tax on that amount during your working years; unlike a traditional 401(k) elective deferral, your Social Security contribution is not deducted when figuring your taxable income. So to tax that amount again when you start receiving benefits would be to tax the same compensation dollars twice. That doesn’t sit well, does it?
To avoid an unfair double-tax, Congress decided to limit the amount of your benefit that’s subject to income tax to no more than 85%. Where did that figure come from? On average, the remainder, 15% of your benefit, is the portion of your benefit that’s funded by your own FICA contributions. The other 85% is funded by your employer’s half of the FICA tax and by investment earnings within the trust fund over your working life. Neither of those components has ever been subjected to income tax, so in that sense it’s fair to do so when you begin receiving benefits.
Congress wisely decided not to try to keep track of your actual tax basis in your Social Security benefit, as you have to do when you make after-tax contributions to a traditional IRA. The 85% number achieves rough justice, so it was deemed good enough.
But that’s not the whole picture. It gets complicated. So as not to over-burden low income people during their golden years, the Tax Code excludes Social Security benefits from the taxable income of low income people; and middle income people are only subjected to tax on 50% rather than 85% of their benefits. Only higher income people are subjected to tax on the maximum 85% of their benefits.
The process for figuring out what portion of your Social Security benefit is taxable (0%, 50% or 85%) is complicated beyond all human understanding. You can find a worksheet for figuring this out in the instructions for the Form 1040. Or just plug in your numbers and let Turbo-Tax do it.
But these three levels of taxation carry an impact of which you should be aware. To avoid an abrupt spike in your income tax when you move from 0% to 50% or from 50% to 85%, the Tax Code creates phase-out ranges. If your particular income tax picture puts you in one of these ranges, your actual—but hidden—tax bracket is much higher than your nominal tax bracket. Maybe one-and-a-half times as big. Which is ironic, since it has the effect of subjecting low income people to a high tax rate.
Another side effect of these phase-out ranges carries an implication for the taxation of municipal bond interest. Interest on state and local bonds is generally exempt from federal income taxation. But it’s nonetheless counted for purposes of determining the percentage of your Social Security benefits that’s taxed. So if you’re in one of the phase-out ranges, in effect municipal bond interest is taxable. But it’s a hidden tax. Nothing's easy, is it?
The good news in all this is that if your taxable income is over a certain threshold, all the complexity melts away, and a flat 85% of your benefits is taxed. No, wait. That’s bad news!
When you start receiving Social Security benefits, are they subject to federal income tax? Not totally. Here’s the story.
For many years social security benefits were totally tax-free. That was a great deal, but it didn’t last. In the early 80’s, as part of an effort to ensure the long-term solvency of the Social Security system, Congress decided to subject part of your benefits to income taxation. (That worked well, didn’t it?) Someone in the government actually keeps track of this little slice of our income tax revenue, and transfers that amount from the general coffers into the Social Security trust fund. But that doesn’t affect us individually, so let’s move on.
When Congress resolved to tax Social Security benefits, they didn’t go all the way. The thinking was this. Part of your benefit is funded with your share of FICA taxes; you know, that’s the 6.2% tax on the first $106,800 (in 2009) of your salary. But you already paid income tax on that amount during your working years; unlike a traditional 401(k) elective deferral, your Social Security contribution is not deducted when figuring your taxable income. So to tax that amount again when you start receiving benefits would be to tax the same compensation dollars twice. That doesn’t sit well, does it?
To avoid an unfair double-tax, Congress decided to limit the amount of your benefit that’s subject to income tax to no more than 85%. Where did that figure come from? On average, the remainder, 15% of your benefit, is the portion of your benefit that’s funded by your own FICA contributions. The other 85% is funded by your employer’s half of the FICA tax and by investment earnings within the trust fund over your working life. Neither of those components has ever been subjected to income tax, so in that sense it’s fair to do so when you begin receiving benefits.
Congress wisely decided not to try to keep track of your actual tax basis in your Social Security benefit, as you have to do when you make after-tax contributions to a traditional IRA. The 85% number achieves rough justice, so it was deemed good enough.
But that’s not the whole picture. It gets complicated. So as not to over-burden low income people during their golden years, the Tax Code excludes Social Security benefits from the taxable income of low income people; and middle income people are only subjected to tax on 50% rather than 85% of their benefits. Only higher income people are subjected to tax on the maximum 85% of their benefits.
The process for figuring out what portion of your Social Security benefit is taxable (0%, 50% or 85%) is complicated beyond all human understanding. You can find a worksheet for figuring this out in the instructions for the Form 1040. Or just plug in your numbers and let Turbo-Tax do it.
But these three levels of taxation carry an impact of which you should be aware. To avoid an abrupt spike in your income tax when you move from 0% to 50% or from 50% to 85%, the Tax Code creates phase-out ranges. If your particular income tax picture puts you in one of these ranges, your actual—but hidden—tax bracket is much higher than your nominal tax bracket. Maybe one-and-a-half times as big. Which is ironic, since it has the effect of subjecting low income people to a high tax rate.
Another side effect of these phase-out ranges carries an implication for the taxation of municipal bond interest. Interest on state and local bonds is generally exempt from federal income taxation. But it’s nonetheless counted for purposes of determining the percentage of your Social Security benefits that’s taxed. So if you’re in one of the phase-out ranges, in effect municipal bond interest is taxable. But it’s a hidden tax. Nothing's easy, is it?
The good news in all this is that if your taxable income is over a certain threshold, all the complexity melts away, and a flat 85% of your benefits is taxed. No, wait. That’s bad news!
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