Our government wants to get paid. Tax rules require all people reaching age 70.5 (after April 1 of the year in which you turn 70.5) to begin drawing income from their IRA or 401(k) — that’s so those deferred taxes you have been waiting to pay will now be turned over to the IRS. It believes you have waited long enough to use your money and now it’s time they want to use it, too. If you don’t need the money and won’t start taking this income, then the IRS will force you to by charging a 50 percent penalty plus the ordinary income tax if you don’t!
The required yearly payout on a $200,000 tax-deferred fund at the age of 70.5 is $7,299. You will then need to pay tax on this amount at
whatever tax bracket you are in at age 70.5. To add insult to injury, this additional income may force your Social Security benefits for the year to be included in your income on your tax returns. You could then lose an additional $5,000 to $6,000 as you pay tax on the Social Security benefit as well!
Following are the rules for including Social Security benefits for income tax purposes:
- If you file a federal tax return as an “individual” and your combined income* is:
- between $25,000 and $34,000, you may have to pay income tax on up to 50 percent of your benefits.
- more than $34,000, up to 85 percent of your benefits may be taxable.
- If you file a joint return, and you and your spouse have a combined income* that is:
- between $32,000 and $44,000, you may have to pay income tax on up to 50 percent of your benefits
- more than $44,000, up to 85 percent of your benefits may be taxable.
- If you are married and file a separate tax return, you probably will pay taxes on your benefits.
*Your adjusted gross income
+ nontaxable interest
+ ½ of your Social Security benefits
= your “combined income.”
A simple solution to the taxing of your Social Security benefits is to convert any deferred accounts like IRAs and 401(k)s into a Roth IRA. Converting to a Roth, however, only makes sense if you have the time to pay the taxes on your funds now, since with Roth IRAs you must pay the income tax up front, or in other words on the “seed.” A tax-deferred program such as a 401(k) defers the tax until later, with the assumption that you will be in a lower tax bracket later in life and thus pay less taxes but this isn’t necessarily true, as I have pointed out with the Social Security benefit. Plus, if you have done what you should and have planned well, you should have a lot more money than you did in your working years! Of course you will not be in a lower tax bracket at retirement, and shouldn’t be! So now, not only do you have to pay a higher percentage of tax due to your increased income, but you must also pay tax on not only that which you initially invested in your fund (and on what your employer contributed as well) but on all the earnings the fund has accrued over the years. This means you will pay tax on the “crop.” What would you prefer, being taxed on the seed or the crop? Most people don’t think about this when they are dumping money into their employer-sponsored programs.
If you can, pay tax now, once, and be done rather than paying tax later with every distribution you take every year and possibly for the Social Security benefit for that year as well for the rest of your life.