When, Why and How Do Social Security Benefits Become Subject to Income Tax?

Social Security was established in 1935, due to so many elderly people going hungry during the Great Depression.  President Roosevelt felt people were losing hope.  The Welfare Department was established and Social Security began.  In the past, FICA tax paid into the Social Security system on a portion of income was never subject to income tax.

With that historical background, now let’s take a closer look at Social Security today and how it works 75 years later. I have researched over 50 of my clients at all ages by examining their Social Security benefits statement and this is what I’ve found:  The average portion that you will have paid into FICA tax during your working life will be close to $43,000.  Using the monthly income that the government promises to pay you for your lifetime, I have found on average that within two years you will have received all $43,000 back into your pocket.

Now what if you made a lot more money, thus had to pay more in FICA tax?  Your benefit will be higher, of course.  But you will still
have received back all that you paid within about two years.   Now does your Social Security benefit stop after you receive back everything you put into the system? Of course not, and if you, me, or anyone else lives to today’s average life expectancy of 84 for men and 87 for women, you will receive over $400,000 in Social Security benefits!  This could be considered the Social Security deal-of-a-lifetime:  Pay in $43,000 over 30 years and get back about $400,000 over 20 years.  This is the best pension deal anyone has ever had! 

But, and it’s a big but, Congress never planned on this happening when it instigated the Social Security system.  In the 30’s, 40’s and even 50’s, most people retired at age 65 and died five to 10 years later. But that started to change in the 1960s and today has exploded into this huge payout.

How can the government afford this?  The answer of course is it can’t!!  When Congress voted to cut benefits in the early 1980’s to deal with the problem of a huge payout it could not afford, citizens pushed back hard and the effort to cut Social Security was abandoned. Then someone suggested the government tax Social Security benefits to help make up the drag on the system, and thus Social Security income is now subject to tax. All retirees get their same Social Security income and since so few people actually check their tax returns, no one seemed to be pushing back on this new tax law. But with that change, retired people instantly lost 20 percent of their income without even realizing it. 

With that historical perspective, let’s now look at what that means for you today using the Social Security tax rules as of 2015 using the base amount showing on your tax return as “Modified Adjusted Gross Income”:

Single: $25,000 – $34,000, then 50% of Social Security is subject to income tax.  If income is greater than $34,000, then 85% of your benefits become subject to income tax.

Married Filing Jointly:  $32,000 – $44,000, then 50% of Social Security income is subject to income tax.  If income is greater than $44,000 then 85% of your Social Security benefits become subject to income tax.

Here is the bad part of this formula.  You have to use one-half of your Social Security benefits to establish your base income for this formula.  Example:  A person receiving $1,800 a month from Social Security multiplied by 12 months = $21,600.  Half of this, $10,800, must be included as income, which could force Social Security benefits to be taxed. A person can only earn up to $25,000 from all sources or benefits will be taxed.  Retirement income from IRA or 401(k) accounts can easily exceed this amount,  so when someone is so proud they saved a lot of money in their tax-deferred 401(k) plan, they just assured themselves of getting a haircut on their Social Security benefits.

Congress has deceived us, in my opinion.  Hindsight says they should have just told us they will reduce benefits according to the length of life.  If they would have done this in 1950, or 1960, or 1970, there would not be such a problem today.  Watch out for changes, because the government can NOT keep paying out this much money to all the Baby Boomers retiring at the rate of 10,000 each and every day. 

A potential solution for you is to convert any tax qualified savings accounts like IRAs, or 401(k)s, to a Roth IRA, which means you have to pay income tax when you do the conversion, but once converted, this money will never be taxed again.  So it is better to convert early in your life so that the growth does not compound your income taxes and force your Social Security benefits to be subject to income tax.  This effort will take planning, organization, knowing the rules and controlling your spending to have enough money to pay taxes today and not allow investments to grow tax-deferred and crush Social Security benefits at a time when you really need them the most. If you need more help, contact me:  peter@moneymastery.com.

Know Your Plan Before You Die…

Most employees do not know what their Social Security benefits will be.  They don’t know what their 401(k) will provide for them at retirement, nor when they will be out of debt.  Few employers provide disability insurance if you get hurt or sick, so what will happen if you become sick or hurt?  And health insurance is a “can of worms.”  If you are self-employed, and/or running a small company, many more questions exist than there are answers.  What will you do when you die or your spouse does?

Everyone should know what benefits they are going to enjoy, and communicate with a spouse about them at least annually.  Things change so fast that if you think you have benefits and don’t, you can go broke in a single week!  It is not hard to gather all your financial information together and review it.  When you have a question, make the effort to call and get answers. 

To see how this works in the real world, I want to share one of my client’s stories:

The husband passed away suddenly at age 64 and his wife had never worked outside the home.  He had $20,000 of group term life insurance and they had $52,000 savings in a 401(k) account.  Their home was worth $230,000, but they still had $189,000 mortgage.  The wife is in good health and expected to live beyond the average life expectancy for women of 87.  The husband’s funeral cost $15,000.  The wife has the option of accessing Social Security benefits of $1,245 a month, or to wait another three years and get $1,570 a month.

What would you do in this situation?  Their monthly living expenses before the husband passed away had been $4,000 per month. Now there’s no money to live like that. Will the wife have to sell the house since the Social Security income she could take now will basically pay the monthly mortgage and that’s it?  If she does sell, where will she live and what will she live on?

This couple had not talked about early death or how one or the other would live once one of them passed away — there was never this kind of detail discussed, ever. They just went along thinking nothing would change.  But it did change and the woman in this situation is in a really bad place financially.  And it will change for you too.  It is only a matter of time before big changes come to your world.  Get prepared.  Review all your benefits and make decisions today as if one of you has passed away.  Play this game over and over until you feel comfortable that you have your financial situation right.

In my experience, most people die with nothing more than a simple will. Their assets have to be probated in court until they are cleared for distribution.  This can take two years.  The expense of having a judge decide how to divide up assets can drain another $30,000 off your assets.  And in many cases, the surviving spouse still needs an income to live on.  What if health problems arise?  

The best way to start preparing for coming changes is to stop spending any more money until you have a Spending Plan in place and have learned how to track that plan so you can see where you are wasting money. Once you do so you will find a surplus that you can begin saving. Fund your future with this real money, that comes from getting your spending and debt under control. Then make sure you create a living trust. Transfer your assets into the trust and make sure nothing goes to the court to decide. Go to www.easylegalplanning.com and see how simple it is to get organized and match assets with a real plan document.  Don’t delay and become part of the majority that leaves your family out in the cold, unable to help themselves.  The memory of you that will be left will not be good.  To learn more go to www.moneymastery.com or contact me: peter@moneymastery.com.

The Real Cost of Funding Your Retirement Entirely with a 401(k)

You work hard to save money on a tax-deferred basis so you will have more money after tax.  Then you go to retire and have to pay tax on 100 percent of the money you take out of the 401(k).  So if you thought paying taxes on your annual income was horrible, wait until retirement if all you’ve planned to retire on is a 401(k) or IRA!  Just because the amount you take out as income during retirement is smaller, doesn’t mean you will be in a lower tax bracket.

This illustration sums up the frustration of a tax-deferred retirement account. As you save money into a 401(k), the annual fees are large and loads for early withdrawals will cost even more money. In addition, the market risks cause losses 4 out of 7 years on average.  How is it possible to have enough money for retirement?    

Now, let’s assume that even with all the leaks that are possible with a tax-deferred account such as the fees, market risks, and penalties, you have been able to accumulate a good sum of money for retirement.  When you start taking income, this large sum is wholly taxed, 100 percent! Since you deferred your taxes, now you have a much larger number to pay taxes on. I ask: why would anyone fund their entire retirement using a 401(k) or IRA? It makes no sense. Of course, if your employer is willing to offer matching contributions, then a 401(k) can be one way to help build a retirement, but to rely solely on this kind of investment is foolish in my opinion.

Take a look at the above illustration one more time and ask yourself, “Does it make sense to defer my income taxes?” By deferring your income taxes, you subject all your money to fees, load, market risks and penalties over 40 years.  This cost can eat up all tax savings.  And when you turn on income, now you pay much more in taxes than ever before.  With few tax deductions, you might struggle to have enough retirement income to live on.  Please consider other options than the 401(k) or an IRA. I have loads of information to share with you on all the grand possibilities for retirement you should consider. Contact me today: peter@moneymastery.com  

Beware of “Financial Plaque”… It Can Kill All Your Best Laid Plans

This illustration of plaque buildup in the arteries makes me sick.  Millions of people have plaque that has the potential to cause huge health problems.  The same can be said about the “financial plaque” that so many people carry around with them. They have allowed their spending to overcome their income and use credit almost exclusively to live on. When you consider the interest expense that accompanies this widespread use of credit, the damage can be just as detrimental as plaque in the arteries.

What kind of damage is debt doing to people?

  • No money set aside for emergencies, which are bound to occur.
  • No money set aside for emotional impulse spending, which is also bound to occur.
  • No hope of retiring, ever.
  • Lost opportunities to create wealth that puts money to work rather than working for money.
  • Lost opportunities to help those in need, to create jobs for others, to form philanthropic organizations.
  • Almost certainly guaranteeing problems paying for healthcare in old age.

The remedy for plaque and heart disease is to eat properly, exercise, and get plenty of rest. Financially, the remedy is to build a Spending Plan and track expenses according to that plan in order to create a cash surplus.  Saving that surplus is the same as getting plenty of rest for the body. 

Learn to put work clothes on your savings and send it out the door to work instead of working your entire life to pay off debt. This will bring not only financial health, but physical health and happiness as well. 

To find out what’s building up in your “financial arteries” visit www.moneymastery.com. today.

Habits Can Both Help and Hurt…

Habits help us do things more easily, with less effort.  They cause us to automatically slam on the brakes of our car when we see a ball and small child run out into the street just ahead.  Habits have helped us become right- or left-handed and do things efficiently because of better coordination.

But at the same time, habits can also hurt us. They keep us doing the same thing in the same manner we have always done, sometimes to our great detriment.  Hard to change bad habits such as smoking cigarettes, or constantly complaining about everything, or driving over the speed limit, or not eating healthy can really cause problems. And what about all the bad habits we form when it comes to the way we handle money?

Let’s apply this habit-forming-process to money management.  What is your habit of saving money?  How much and how often do you save?  If you are like 91% of all workers, you save very little and this is why 91% of all retirees are totally dependent upon the Social Security check they receive each month to provide basic living expenses.  This 91% number has been steady for over eight decades.  Anything lasting this long would be classified as a habit, right?  

If you want to change a bad habit, experts say you must consistently do something different for at least 21 days in a row. I think with money habits, it takes at least six months or longer.

Here are some suggestions getting started with better money-saving habits:

  • Start by putting all you loose change in a jar at the end of the day.  With wide-spread use of credit cards, you may not have any loose change.  But try it and see.
  • Each month  add to savings at least 1% of your income.  Anyone, and I mean anyone, can find extra money to do that through tracking every soda you buy and other small expenses. And if you commit to saving 1% for two months, then make it 2% for the next two months after that. Keep this going until you are able to save 10% of your income and then see how different you feel. A habit of saving 10% of your income will add to your retirement income, and give you more options at retirement than what Social Security will provide.

You can do this!  Start today. For more help contact me: peter@moneymastery.com, or visit www.moneymastery.com.

As Older Employees Keep Working There’s Less Room for Younger Workers…

Healthcare costs are much higher because older workers are not retiring.  They stay on and keep their health insurance and take up a place of employment that would normally go to a younger person.  This is why younger folks are having a harder time finding employment (and paying for healthcare).

As older folks keep on keeping on, it will take 15 more years before we see more room at the top for workers who are moving up the ranks. Younger people are finding it hard to compete with tenure of an older employee.  Since older employees have not saved enough to pay for health costs and retire, they keep working and do jobs that many younger folks could be enjoying.

If you are older and have lots of experience, and even own the company you are working for, you are in control.  If you are younger and trying to break into the job market, it is harder to compete when you don’t yet have experience that some jobs require.  So it will come down to a younger person having to work harder than ever to get a good-paying job and acquire experience.  This is only one of the many strange phenomenon of the Baby Boomer generation having not prepared adequately for retirement. 

For more information about how to get prepared now, even if you have put it off, contact me:  peter@moneymastery.com.

Tax Rates May be Lowered… Think about Converting 401(k)s to Roths

If the Trump administration ends up getting taxes lowered, consider converting all IRA and 401(k) savings over to a Roth IRA.  The tax hit today will allow all future growth to be taken out as tax free!

Here are two observations about this advice: 

First, when you take income during retirement from a Roth IRA, you do not pay income tax on it. And this income does not force your Social Security benefits to be included for income tax purposes.  Withdrawals on 401(k) funds, on the other hand, usually force a Social Security benefits to be taxed with a potential $5,000 tax hit since 401(k) withdrawals count towards the earnings formula for Social Security.  Roth IRA withdrawals do not count in that equation so there’s no hit!

Second, when you pay the tax on the Roth IRA conversion today, you or your loved ones don’t have to pay tax on the withdrawals later. A 401(k) is tax-deferred so this means your spouse or kids will have to pay taxes on those withdrawals, or yourself, at a time when you’re on a fixed income, with not near so many deductions as you can take during your working years seeing as your house will probably be paid off and your kids will be grown.  To see what a huge burden  this can be, understand that the taxes you will pay in retirement on the  401(k) payout will be at least SIX times what you will pay in taxes on a Roth conversion now.

Example:  You  have $207,000 in an existing 401(k) and over the next 15 years between now and retirement you contribute  $6,000 a year into the account and it earns 5% interest, which will equal an additional $129,000; at retirement you have $337,000. Take this $337,000 and pay it out over 35 years for yourself or spouse or children and it will be worth $753,000.  Taxes on this total will equal $188,000.  If you converted this $207,000 to a Roth IRA instead and deposited the $6,000 a year into the Roth the tax you will pay is only $28,000.  Compare you paying $28,000 or $188,000, which do you think is better?  The multiplier in this case is 6.7 times!!

If the Trump administration gets taxes lowered, run, don’t walk to convert all tax-deferred accounts to a Roth.  More coming in the near future about how this will impact each of us.  But in short, lower taxes will indeed spur the economy and change millions of people’s lives so that they have surplus money to save.

Retirement Can be Like a Rose, Depending on How You Hold It

A rose is beautiful and we all enjoy them to celebrate special occasions.  But roses have thorns — sometimes we can prick ourselves if we aren’t careful.  Retirement is just the same.  We can enjoy retirement if we hold it just right, but if we refuse to prepare, the thorns we will experience in retirement can cause some real pain.

Here are some of those thorns to consider:

  • Of all people who filed bankruptcy in 1991, 21% were older than age 65. Today that number has grown to 28%.  This destroys credit and prevents ability to borrow money for needed items. If debt levels are really high before retirement age, this can be a real thorn to manage after age 65.
  • Some parents try to help their children with student loans by co-signing on federally insured loans. Later, if the child doesn’t get employment that earns enough money, the parents end up paying on the loan.  This can be a real thorn when it comes to retirement.
  • Another potential thorn in retirement is higher taxes. No doubt you have been taught to save money in a 401(k) or other tax-deferred savings program throughout your working years. Supposedly you will be in a lower tax bracket in retirement years so paying all those deferred taxes in retirement will be cheaper than paying them during working years. But it has been my experience working with thousands of clients that this simply isn’t the case. People in retirement usually pay much  higher income tax than when working because they don’t have any deductions!
  • Another thorn that can cause real pain in retirement is waiting too long to start saving for it.  If you started working at age 25 but did not form a habit of saving until age 55, this could potentially pain you every day of your life in retirement.
  • Having to work until age 80, because you don’t have enough money to retire, can be another real problem.  Maybe you like to work and you don’t mind it. But that’s different from being forced to work. And what if you don’t have the health to do so?
  • What about the fear of running out of money in retirement, which oddly enough, is a much greater fear than dying? I’m sure the reason is that it’s hard to cut spending down at a time we have more free time to spend.  Statistics show we spend more when we first retire than when working.  Apparently it takes a few years to adjust to the new income.
  • The thorn of inflation is real.  It has hurt so many retirement-aged people as their fixed expenses increase while their income does not.
  • The final thorn that can turn a beautiful retirement into a thorny nightmare is the need for dental, vision, hearing and for long-term or hospice care.  The huge prick here is that the costs can exceed your entire savings for retirement, and this might leave a surviving spouse destitute and on welfare.  A HealthView Services study in 2016 shows that the cost for all these elderly care service for a couple age 65+ will be $377,000 during their retirement.

To create a beautiful retirement with minimal thorns, get in touch with a financial coach who can teach you how to deal with each of the things I have discussed above. Contact me today: peter@moneymastery.com.

Are You Financially Playing More Offense or More Defense?

Take any sport and consider playing strategies and defense always seems to win in the end. Let’s take the NBA Playoffs for example. The highest scoring player of a game is held in high esteem, even paid the most money on the team. Crowds cheer when points are posted on the scoreboard. The high scorer gets to do the team interview at the end of game. But nobody posts defensive plays, no system keeps track of how many STOPS a player makes so the opponent cannot score, so why not? I believe the answer is the player that puts up big points is what sells tickets!

Now reference your 401(k) funds: are you on the offense, trying to score the best rate-of-return? Or, maybe you are playing defense and trying not to lose any money? A simple way to find out is to ask yourself, “Am I going for the best return I can get?” If so, you are on the offense. But history of all sports and all battles in war shows that a good defense wins most of the time, so why aren’t we all playing defense? I believe that defensive savings and investing isn’t as exciting as trying to get a higher rate of return, and doesn’t “sell tickets” so to speak.

So think of your mutual fund manager: Doesn’t he or she emphasize investments that have posted larger rates-of- returns to get you attention? If that is what you want, the best return, you buy into this, meaning you become the “sale.”

Defense definitely wins more games than offense. With a strong defense you shut down a hot offense, that is why you win most often. So when you invest your money, why not switch away from the mentality of always trying  to get the highest returns and play defense? Try playing defense with a small portion of your investment money. Go for the solid, never-lose investments so you don’t lose big and have to gain back better-than-average returns, especially if you have no time left in the “game” to recoup such losses.

Can you imagine how much more money you would have if you just had the money back that has been lost? I’m guessing it’s a huge number! Please consider going on defense with your investments and keep track of what happens. You may find that defense wins most often, just like in any sport. For more help on this subject email me:  peter@moneymastery.com.

What Happens When You Earn 75 Cents and Spend $1

Did you know that for every 75 cents the U.S. government is taking in, it spends $1?  Further, if this continues, within ten years the 75 cents will be used to pay just the interest on the debt.  Shame on the government — but wait, shame on all of us as this is exactly what we are doing with our personal finances. That’s why the average person reaching age 65 still has a mortgage, still has credit card debt, and is still worried about retirement.

The solution to all this nonsense is to spend less than we make.  I challenge you to do this for one month and see how great you feel at the end of it! Then try to see if you can do it for two months and so on until you are saving 10 percent of your income each month.  To accomplish this you must build a plan to spend your money differently.  Go to www.moneymastery.com and sign up for the select program.  Use the online software to build three plans:  Spending, Debt and Retirement.  Then look at how all three can be worked on at the same time. For more information and help, please contact me: peter@moneymastery.com