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.

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.

How to Live a Long Life and Love It

One of the secrets to living a long and happy life is to save 10 percent of your income for the rest of your life.  If a person can save 10 percent of their income when they are a teenager, they are smart.  If a person can save 10 percent while going to college and not incur student loans, they are brilliant.  If a person can save 10 percent up and through their working years and into retirement, they are an absolute genius.  Which one are you?

Take the example of a person you work with who always comes to a scheduled meeting late.  That is just them.  They are late, late, late all the time!  Ask yourself why?  To me it is a habitual thing.  They just don’t plan to be early. 

So it is with money. Many people just don’t plan to save as much as they should. Why is it that most people don’t have money saved for an emergency? To me it is a habitual thing.  They just never got in the habit of doing it, so they have no plan to secure it. In addition, they don’t save money into the right categories. Not only should you be saving 10 percent of your income, but you should split that savings into three categories:

  • Emergencies
  • Emotional
  • Long-term (Retirement)   

Nothing will derail a long-term retirement plan quicker than putting all your eggs into a deferred investment program where you have no access to liquid funds. Break off some of your savings into a liquid passbook savings account that you can get at in case of an emergency, because they are guaranteed to happen. If you have nothing with which to replace the broken water heater, for example, you will put that expense on a credit card and incur further debt. Piled up debt will eat into all that long-term retirement money when it comes time to withdraw it. And on top of that, it’s not likely that the conservative funds you are invested in with your 401(k) or other IRA program are going to give you a rate of return greater than the rate of interest you are paying on your debt.

Another event that’s sure to happen will be emotional spending, where you spend money for nothing more than pleasure or impulse. There is nothing wrong with this, if you have planned for it, because this impulsive spending is bound to happen to all of us. The problem is when you don’t have any money saved for such events in an emotional savings account. You see a  new pair of shoes you really must have and purchase them on impulse with guess what — that’s right, your credit card. This kind of spending without a liquid savings plan to account for it will, just like emergencies, pile up debt to the point that your retirement income is in jeopardy.

Breaking old habits — like not putting any money away or worse yet, not putting that money into the right savings categories — is hard to do.  But it can become easier if you forecast yourself into retirement and envision what it will be like if you haven’t saved for emergencies, emotional needs, and long-term goals.

We all can learn new tricks, even if we are old dogs.  Don’t give up. Read the book, MONEY:  What Financial “Experts” Will Never Tell You” for some great info on how to start saving today, even if it’s only 1 percent, and working your way up to the magical 10 percent amount — a savings amount that truly will affect whether you live a long and happy life, or not.

When Did the Concept of “Retirement” Come to Be?

As you can well imagine, the idea of “retirement” did not exist in Roman times, nor medieval times, and certainly not when Pilgrims discovered America.  What about during the days of Lewis & Clark?  Or when the wild West was being settled?  History teaches us that a Roman peasant had to fight for food every day of their life.  A peasant could not even fathom taking life easy, sitting back to watch the evening news, or going out to eat and taking in a movie. How could an English Lord even conceive of “retiring?” He had to manage a kingdom and train new knights to protect him and his vassal serfs.

Some examples of newly created words, along with the idea of “retirement” in the last 100 years include:

  • Internet
  • World wide web
  • iPhone
  • Light bulb
  • Polyester
  • DVD
  • Contact lens

We have seen so many advances in technology and medical care in the last century that we have a lot more time on our hands than anyone born before the turn of the last century. That extension of life plus all that time we have available has been the reason the idea of retirement even exists.  “Retirement” is a new concept, only around since just before World War II broke out. Up until 1920, most people died before they reached the age of 60, so retirement wasn’t even an option.  When people started to live past age 65, some elderly folks started to save money for when they could no longer work, and thus the concept of retirement was born.

Four problems came along with this new concept. The first problem is outliving your income. Today 92 percent of everyone who is retired is totally dependent upon their Social Security benefit.

A second huge problem is inflation.  Just use your Web browser to see what one gallon of milk cost 20 years ago and you will be shocked.  You will most likely need to double the money you think is needed at retirement, because of inflation.

A third problem is continual taxation.  As you take money from you retirement savings plan to live, this income is taxed and can cause Social Security benefits to be subject to income tax as well.

A fourth gigantic problem is the cost of medical, long-term care and nursing home expenses.  The national average shows costs for a retired couple for medical/nursing care is $250,000 before they die.  This kind of cost is eating up all possible savings most people manage to squirrel away for retirement.  When all resources have been exhausted, the surviving spouse becomes destitute and is classified as being on welfare.

Considering these four problems, now is the time to decide what “retirement” means to you and whether you will be able to make that vision a reality. You have heard about the importance of planning for retirement your entire life, while those who lived before 1920 did not even have an inclination of what that meant. Before it’s too late, define what you want to happen when you reach age 65 because unlike your grandpa and great grandpa you will likely live longer than 60 years, so you will need to be prepared for that long life and how you want to live it.  It’s never too late to get going on this.  Go to moneymastery.com and sign up for the Basic online training package and see for yourself how much money you need to be saving for retirement, or calculate how long your money will last. For more help, contact me directly: peter@moneymastery.com.

What Happens to You Financially If Your Health Changes?

According to the Social Security Administration, 41 percent of all workers are required to retire earlier than planned due to a personal health problem — that’s four out of every 10 Americans. And the National Council on Aging has stated that about 91 percent of older Americans have at least one chronic health condition; another 73 percent have at least two.

What will you do if you’re one of the four out of 10 people who have to retire early?  How will you manage, and do you have enough money?  Get serious and create a plan based on the assumption that you might have this problem. After all, as stated above 91% of all seniors have a serious health problem — don’t gamble with those numbers and hope that whatever condition you get won’t keep you from working as long as you need to.  

Here are three things to do if you physically have to retire:

1.  Cut spending down to what money is available.

2.  Apply for Social Security benefits under handicapped status. This may take 6 months, but can help your income a lot.

3.  Stay mentally engaged with family, community and friends.

As you rearrange living expenses, this may lead you to consider downsizing your home.  This can help lower the cost of utilities and property taxes.  Think long-term when you are making these adjustments.

The Social Security administration has provided for those who get disabled at an age younger than 62.  This could be a source of income for the rest of your life.

When people finally retire, the most successful are those who stay actively engaged with the world.  They volunteer to make a contribution to the community around them.  By staying engaged, they are more alert and have a higher quality of life.

Plan for the event of bad  health and then if it doesn’t happen, you’ll still have the extra money plus you’ll have peace of mind, no matter what happens, and that is worth its weight in gold. peter@moneymastery.com.

Have We Become a Nation of Spoiled Brats?

In 1935 our nation was in the worst economic depression of all time.  Unemployment was at 40% and senior citizens did not have enough food to survive.  President Roosevelt created a welfare system called Social Security.  It was designed to help give the bare necessities of life to the very poor of the poorest. When this new welfare system went into place the average person was living to the age of 67.

Fast-forward to today and we see that the average person reaching age 65 will live to be age 84 for males and age 87 for females.  The average family will have made $2,500,000 over their lifetime of work, yet have less than $60,000 of total assets to show for it, including equity in their homes! To top this off, 91% of all people retired are totally dependent upon their monthly Social Security check.

What happened between 1935 and today?  My thought is we got spoiled with all the new growth of our nation’s population and technology. We took for granted our better education, incredible travel opportunities and medical improvements.  We assume all these improvements are just expected and natural and assume they will never stop!  In short, we have become spoiled.

If we went without the latest gadget, clothing fad, classy automobile, and foreign travel, surely as a nation we could have saved more by now.  We have not been willing to wait for things we want and have spent our future.

Don’t be one of our nation’s spoiled brats. Learn how to control spending and get out of debt!  This applies to me just as much as it does you. In a country where there is so much opportunity to spend, it can be hard to learn how to control it. But we can all do better and we should.  Let me just be the voice of warning to help encourage us to change our course of action and do better.  For help, please contact me: peter@moneymastery.com

Social Security: Will It Be There for You?

Answer to this big question:  Since you pay 7.15% of your income to FICA, you have a right to receive what you pay for, right? So will the money be there when you need it?  My answer is a well-educated guess:  

You will get some benefit, but not even close to what is being projected. 

The reason I give for this is because we cannot possibly afford all that we have committed to our Gross Domestic Product (GDP).  The Congressional Budget shows that our statutory commitments, meaning what is already law, commits our total GDP to these prior agreements, all since 2009.  This is seven years of commitments larger than available money.  How can the government possibly keep this going and expect to pay out full Social Security benefits?

The point I am making is YOU need to save money and stop counting Social Security — become independent from any government benefit.  If you do receive some amount of Social Security income, then great — you will be both surprised and happy.  But to plan your retirement around this income is foolish in my opinion. Make changes today, to create a cash surplus that can make you more. For information on how to do this, contact me: peter@moneymastery.com.

Cost of Medical Care After Age 65 Will Bury the Nation… and Probably You As Well

National statistics report that healthcare costs for retired persons average $250,000 from age 65 through the remainder of life.  How can a retired person (or anyone for that matter) afford this expense?  Statistics show that 91 percent of those retired are totally dependent upon Social Security benefits for their monthly income.  How can any retired person take their Social Security income and carve out an extra $250,000 to pay for health care?  This is an impossible task!  If anything is done to curtail Social Security benefits it will totally destroy the senior class.  Medicare is soon running out of money and Medicaid is broke.  I predict healthcare costs will be the largest hammer to come down on our financial world in the next five years. 

As you read this article, take inventory and ask how you will pay for healthcare costs in retirement?  If you do not have an answer, then you will probably be in this same group of people in the U.S. who are currently incurring $250,000 in medical/nursing home expenses that eat up all their retirement and life savings because they were not prepared.  If you are not saving adequate money for retirement, then healthcare costs will eat up what little you have saved and destroy you right along with our nation. 

I suggest 91 percent of the population needs to cut all expenses and not buy new homes, new gadgets, new cars, or go on expensive vacations until they  have saved, saved, saved!  Times are troubled and only promise to get worse for those who are in debt and have not established passive income they cannot outlive. If you are counting on Social Security and a risky 401(k) plan, you have no chance of survival.

Gloom and doom you say? It is what it is.  The real magnitude of the situation just hasn’t hit the fan in your own living room yet, so you don’t see it but it’s coming.  Plan on making changes now, while you still can.  My word of caution is take action today! For more ideas on how to do this, contact me for a no cost consultation: peter@moneymastery.com.

What the Future Holds for Tax-deferred Accounts

Don’t you think it is better to have one bird in the hand, than two birds you can see in the bush?  Of course! Then why do so many people defer their taxes by using 401(k) plans, or others like it, when the future and the markets are so uncertain?  We all know the federal government is overspending.  We all know the feds cannot possibly pay out the Social Security and Medicare benefits it has already committed to.  Do you think taxes just might go UP?  Wouldn’t it be better to pay taxes now, and then never again? 

Since the average person reaching age 65 has less than $60,000 of total assets, why would you consider to deferring taxes until the worst possible time in your life, when you can least afford to pay them?

Consider this: When you start drawing money from these tax-deferred plans it can easily force your Social Security benefits to be included for income tax purposes also, meaning you will pay at a higher tax bracket.  So knowing this in advance, it’s time NOW to reconsider how you really want to fund retirement and how you want to pay your taxes. Don’t just go with what everyone else is doing, consider that there might be many other viable options for creating a predictable retirement you cannot outlive than throwing money into a 401(k). Contact me for these ideas:  peter@moneymastery.com.