Sources of taxable income in retirement

Finance hacking enthusiasts spend a vast amount of time minimizing the taxes they pay and shielding income and assets from taxation in the future. These techniques range from the commonsensical (max out IRA contributions each year) to the unhinged (name your favorite front-door/back-door/side-door/trap-door IRA strategy).How deep you decide to go into the weeds of managing your tax liability is up to you. But you're exceedingly unlikely to make the right decision if you don't have a grasp of what your tax liability is, in fact, likely to be, and it appears to me that many tax minimization antics are predicated on a grossly exaggerated idea of the tax code's actual burden.With that in mind, I want to break down three sources of taxable income in retirement and indicate what tax rate each source is likely to incur.

Earned income

There's no rule that says you have to stop working once you retire, and in fact it appears to me that most retirees of the finance hacking genus continue to earn income, whether it's through real estate management, blogging, or some other activity. This earned income is taxed at the normal income tax rates, which is to say the first $10,350 in earned income ($20,700 for married folks) is untaxed. After that, you'll pay a modest 10% or 15% marginal income tax rate on additional income until your earned income reaches mid-to-high 5 figures.

Capital gains and dividends

Long-term capital gains and dividends are taxed at preferential tax rates and it's absolutely essential to keep in mind that these are marginal tax rates, just like the ones I discussed last week. As this post clearly explains, you don't need to worry about triggering a higher tax rate on your long term capital gains by "accidentally" having too much earned income or too many realized capital gains: the high tax rates are only applied to additional dollars on the margin, so the lowest preferential rates will still apply to every dollar of capital gains that's eligible for them.The categories of earned income and capital gains interact in an important way. Look at the two categories in conjunction: a single person can earn $10,350 in earned income to "fill up" their standard deduction and personal exemption, then an additional $37,650 in realized long-term capital gains and qualified dividends at the preferential 0% tax rate. And if they earn more income or realize more long term capital gains than that, only the marginal dollar is taxed at higher rates — the first $48,000 is still tax-free.The terror of triggering higher tax rates appears to me to be based on the misconception that the higher rate applies to one's entire income. That's just not so.

Social Security

If your only source of income in retirement is Social Security (and Roth retirement savings accounts) then you'll never owe income taxes in retirement. However, under certain circumstances part of your Social Security benefits is added to your taxable income before calculating the income tax you owe:

• if your AGI plus nontaxable interest (e.g. from municipal bonds) plus 50% of your Social Security benefit is between $25,000 and $34,000, you may have to add 50% of your Social Security benefit to your taxable income;
• if it's above $34,000, you may have to add 85% of your Social Security benefit to your taxable income.

Avoiding the tax on Social Security benefits is one reason folks are so eager to put as many of their retirement assets as possible into Roth accounts, withdrawals from which don't trigger the tax on Social Security benefits. And indeed, if you have earned income and taxable capital gains and Social Security income, you're more likely to owe some tax on your Social Security benefits.However, it's worth taking a look at the case of someone with just Social Security benefits and taxable capital gains. In this case, if your taxable long term capital gains plus half your Social Security benefit requires you to report half your Social Security benefit as taxable income on Form 1040, line 20b, the federal income tax will apply first to that amount, meaning you'll owe no federal income tax on up to $20,700 in Social Security benefits, and then no long term capital gains taxes on the same $37,650 in long-term capital gains we calculated above.In other words, even if your Social Security benefit is taxable, you still might not owe any taxes on it.

Conclusion

There are a lot of common sense strategies, and some esoteric strategies, for maximizing the assets available to you to fund retirement, whether you decide to retire early, late, or right on time, and my intention isn't to say "tax planning doesn't matter." Tax planning can matter.However, if you don't have at least a preliminary grasp on what you're likely to actually owe in taxes, then you are vanishingly unlikely to make smart decisions about how to invest, where to invest, and most importantly, how much time to spend researching your options!

Why "narrowly focused" middle-class tax cuts overwhelmingly benefit the wealthy

Since the White House finally got around to announcing the outlines of their tax reform plan today, I want to briefly address an issue that's generally ignored in discussions of income tax rates and brackets.

Marginal tax rates mean you pay taxes at lots of different rates

You often hear as shorthand that "the wealthy pay a 40% income tax." That's exactly wrong: the wealthiest Americans pay a 39.6% marginal income tax rate. If a single person reports a taxable income of $418,401 in earned income, they pay a 39.6% income tax...on exactly one dollar.On the first $470,700 in taxable income, the person pays 10% on $9,325, 15% on $28,625, 25% on $53,950, 28% on $99,750, 33% on $225,050, and 35% on $1,700. Only after paying all those tax rates does our single taxpayer begin to pay 39.6% on additional dollars of income.

Tax cuts disproportionately benefit people who fill up each tax bracket

Let's say that we decide the middle class is working longer hours for less pay and that the solution is a tax cut for hardworking middle class families (insert gagging sound effect here). $50,000 in taxable income seems like a good place to target our middle class tax cut, since that would imply about $60,400 in earned income, a solidly middle-class income. $50,000 in taxable income falls in the 25% tax bracket, so what happens when we cut the 25% marginal tax rate all the way down to 15%?Our solidly middle-class taxpayer saves $1,205 in federal income taxes: 10% of the amount of taxable income in excess of $37,950.Meanwhile, how much would someone making $100 million in earned income save? They'd pay $5,395 less in federal income taxes, 10% of the entire $53,950 bucket of earned income.And remember, this is the outcome of a federal income tax cut narrowly focused on middle-class taxpayers.But in this day and age, who can survive on $50,000 in taxable income? Let's raise the threshold for our narrowly focused middle-class tax cut all the way to $100,000, which puts our single middle-class taxpayer in the 28% tax bracket, and we'll cut the 28% tax bracket down to 15% as well.Now our solidly middle-class taxpayer gets to save the entire $5,395 in federal taxes our titan of industry saves, plus an extra $1,053: 13% of her taxable income in excess of $91,900.But sure enough, our hedge fund manager wins again, saving $12,967 (13% of $99,750) plus the $5,395 saved in the lower bracket.So much for narrow focus.

The only way to narrowly focus a middle-class tax cut is to raise marginal tax rates on higher incomes

This is a mechanical outcome of the nature of a system of progressive marginal income tax rates, and there's nothing that can be "done" about the savings the wealthy get from cuts to marginal tax rates in the lower income tax brackets.On the other hand, there's no secret to "narrowly focusing" a tax cut on the working or middle classes: you recoup the money saved by high earners through higher marginal income tax rates on the upper brackets.To recoup the $5,395 saved by high-income taxpayers by cutting the 25% rate to 15%, you can raise the 33% bracket by 2.4%. To recoup the $12,967 saved by lowering the 28% bracket to 15%, you could raise the 33% bracket by 5.8%.Note that this would still constitute a net federal income tax cut on everyone with taxable income up to $416,700, since only at that point will the entire tax savings in the lower brackets be recouped.

The idiocy of an "across the board" tax cut

To be clear, I'm not in favor of any of the above proposals because I don't think our middle class is suffering under the cruel yoke of an expropriating tax code. But even if you think taxes should be lower, even if it's out of pure greed, you have to understand that the wealthy receive a federal income tax cut when tax rates on lower incomes are lowered, even if the marginal tax rate on higher incomes is unchanged.You do not need an "across the board" in order to cut everyone's taxes. Cuts exclusively to the marginal tax rates of lower tax brackets not only benefit high-income taxpayers, they disproportionately benefit high-income taxpayers.

Why should retirement savings be financed out of current income?

If there are two axioms that financial graybeards treat as indisputable, they are:

• Americans don't save enough money for retirement;
• and the government needs to do more to encourage retirement savings.

With respect to the first axiom, we're treated to serious-looking charts about the "retirement savings gap" and told how few people are taking advantage of workplace savings accounts. It seems to me that this is a complete misunderstanding of the problem, which is that people are assigned a task they have no training or competence for, and that modestly raising Social Security benefits would be a much more straightforward way to ensure retirement security. But if you prefer this "personal responsibility" routine I won't argue with you here (we can get into it in the comments if you like).My problem is with the second suggestion, that the government encourages retirement savings. It does no such thing. On the contrary, government policy is currently engineered to actively hinder people from accumulating adequate retirement savings.

Forget everything you know about retirement savings

It is a very tempting trap when discussing issues of general familiarity to anchor the discussion on programs and policies that already exist. In other words, if I tell you IRA contribution limits are too low, the easy impulse is to say they should be raised. If I tell you taxes on distributions are a drag on performance the easy impulse is to cut or eliminate those taxes.I want you to momentarily put aside everything we already know about the system of tax-advantaged retirement accounts in the United States while I show you two charts. This is a chart of the growth of an account that has $5,500 added to it each year and that compounds at an annual rate of 5% APY for 40 years:This is a chart of an account with the same $220,000 in contributions made in the first year and allowed to compound for 40 years at 5% APY:Obviously I haven't picked these numbers at random. Someone who begins working at age 25 and contributes the maximum $5,500 every year until they retire at age 65 will have contributed $220,000 over the course of 40 years.The current policy, in other words, of the US government is that you should save $220,000 for retirement but, by contributing it out of current income each year, you should only retire with 41% of the assets you'd have if you'd invested the full amount in your first year.Now you tell me, is the US government encouraging Americans to retire with adequate resources, or discouraging them from it?Even worse are the so-called "Catch-Up" contributions which allow individuals over the age of 50 to make additional contributions to their retirement plans. That's right, you're supposed to "catch up" by making contributions as late as possible, when the money will do the least good by having the least time to appreciate and compound!

This is a system of labor subsidies, not retirement subsidies

All you need to know about Individual Retirement Accounts is laid out clearly by the IRS:"For 2015, 2016, and 2017, your total contributions to all of your traditional and Roth IRAs cannot be more than:

• $5,500 ($6,500 if you’re age 50 or older), or
• your taxable compensation for the year, if your compensation was less than this dollar limit." (emphasis mine)

A year in which you make nothing, or less than $5,500, is effectively excluded from the number of years you can make contributions to so-called "retirement" accounts. If your belief is that elderly Americans don't have adequate income in retirement, why would your solution be to punish those with spotty or incomplete work histories by reducing the amount of retirement assets they are permitted to appreciate tax-free? If you suffer unemployment or imprisonment early in your life, you're forbidden from making contributions in the very years they would be most valuable in retirement!The game becomes even more obvious when you see how these programs interact with one another in practice:

• you have to have taxable income to make an IRA contribution;
• if your AGI is low enough to qualify you can receive a Retirement Savings Contribution Credit;
• but the Retirement Savings Contribution Credit can only offset taxes owed — it's non-refundable and thus cannot actually increase someone's retirement savings.

A modest proposal: burn it down and start over

Here is my two-part plan. Feel free to share it far and wide:

1. Eliminate from the tax code all of the following provisions and programs, and any other "retirement" scheme you can think of: 401(k), 403(b), SEP, SIMPLE, Solo 401(k), IRA.
2. Create a single tax-advantaged account with the following features: a lifetime cap of $200,000 (indexed to inflation) in after-tax contributions, starting at age 18, which compounds tax-free and with tax-free withdrawals of any amount at any time.

That's it. I do not think that people are very good at saving for retirement (which is why we need to strengthen Social Security), but for those with the talent or inclination to do so, this would allow them to shield a substantial, fixed amount of money from the drag of annual taxes on distributions, which they're welcome to use in retirement or for any other purpose.Here are four conceivable objections (besides the obvious "I'm taking advantage of my 401(k) and I don't want you to take it away." That's not an objection, that's greed. Go sit in the corner):

1. Rich people will make $200,000 contributions on the day their kids turn 18. Yep, I'm not thrilled about that either, but I don't care enough to punish everyone the system will help by trying to monitor or prevent it. Also, rich people don't trust their kids, so I suspect this problem will be less serious than it seems (unlike the 529 problem, which is real and serious, because parents maintain ownership and control of accounts). The impulse to impose high fixed costs on everyone in order to prevent abuse by a tiny minority is a serious and endemic problem in American politics, which you often see in discussions about preventing "abuse" of the welfare state.
2. By not earmarking funds for retirement, people will make early withdrawals to cover non-retirement expenses. Yep. Fortunately, most people will not max out the $200,000 contribution limit, so even if they "waste" $10,000 of it by making a contribution and withdrawing it shortly after, they still have $190,000 before they hit the cap. This is an insignificant problem that will affect almost no one.
3. Employers should be involved in some way. No, they shouldn't. That's anchoring on our current bizarre system where large employers have a competitive advantage over small employers because they can afford to administer large retirement schemes. If you want to make regular contributions from your paycheck, set up direct deposit. Involving employers in the administration of government programs is a tendency we need to beat back at every opportunity in order to build a society of entrepreneurs and entrepreneurship.
4. There should be a way to make pre-tax contributions. No, there shouldn't. A pretax contribution by a high-income person costs the taxpayer more than an identical contribution made by a low-income person, forcing taxpayers to pay more to subsidize the retirement security of the wealthy than the poor! That's the perverse logic of pretax contributions (it applies equally to so-called Health Savings Accounts).

Conclusion

Since man is a social creature, the way we think about things is often constrained by the way we talk about things. That's why people think Individual Retirement Accounts are about saving for retirement, 529 plans are about making college affordable, and Health Savings Accounts are a good way to pay for healthcare.As I explained in my introductory post, I have an unfortunate literal tendency which leads me to take things as they actually are, not as people pretend they are. And what we have now is a system rigidly engineered to obstruct those saving for retirement from taking advantage of the most powerful tool in their arsenal: the time for the power of compound interest to work miracles on their behalf.The correct way to address problems is to address the problem. When people were unable to get health insurance because of pre-existing conditions, we passed guaranteed issue. When lifetime caps on benefits left people without health insurance coverage, we banned lifetime caps on benefits.But when people were suffering from income insecurity in retirement, we pretended to address the problem by building a system of expensive and complicated labor subsidies. That system will never work because it was never designed to work.It's time to start over, and do it right this time.