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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.
Sunday, May 3, 2009
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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