Source: ezinearticles.com
It was in 1974 that the IRA was born and we were assured by the government that by putting our money into a retirement plan today, we could reduce our current taxes and pay a lower rate in retirement.Life was simpler then.It was easy to project a lower tax rate because the top tax rates were in excess of 70% and Social Security benefits were not subject to income taxes. Basic common sense told us to put our hard-earned money into tax deferred retirement plans assuming the future tax rate would belower.
This message of tax deferral has never changed.Yet after the Tax Simplification Act of 1986 the top tax brackets were less than one half of the 1974 rate.With the lower tax brackets, 85% of taxpayers fall in the 15% tax bracket or lower. This means that taxpayers contributed significant portions of funds now in retirement plans while they were in or below the 15% tax bracket.What are the odds that their tax rate will be less than 15% in retirement?
Much has changed in the tax code since 1974.A "provisional income test" now determines the portion of what once was tax-free social security benefits that are now subject to income taxes.Because of this test, income sources such as an IRA distribution could increase the taxable portion of social security in addition to the tax due to the IRA distribution by up to 85%.In other words, with no other change to income or deductions, a $10,000 IRA distribution could increase taxable income by $18,500.A retired taxpayer could pay federal taxes on IRA distributions in excess of 27% even when remaining in the 15% bracket; the rate could be even more for taxpayers in the 25% tax bracket.State income taxes only exacerbate the tax rate.To say the least, the provisional income test makes estimating income taxes on IRA distributions quite complicated.
Even though property taxes have skyrocketed along with property values, fewer and fewer taxpayers itemize their deductions.This means that for many taxpayers, income taxes are the same with or without deductions. Taxpayers with IRA distributions have to calculate the taxes due on IRA distributions dedicated to the payment of property taxes.
Consider several middle class couples age 65 living in Minnesota.Each is retired from a job that has provided a pension.Assume each has nearly identical circumstances with combined Social Security benefits and pensions of $30,000 each for total cash flow income of $60,000 and file taxes as married filing jointly.The only difference in their circumstances is the property taxes of the mortgage free homes in which they live of $1,900, $3,800, $5,600 and $7,400.All other itemized deductions are the same and are not enough to exceed the standard deduction for their age and filing status.Without an IRA distribution and after the standard deduction and exemptions, each would pay federal taxes of $1,595 and Minnesota taxes of $827.Each couple is squarely in the middle of the 15% tax bracket.
These couples live comfortably on the pension and Social Security retirement benefit, therefore each has decided to use IRA distributions for the sole purpose of paying property taxes.The income tax consequence of the distribution needs to be determined and paid.Since each of the taxpayers is in the 15% tax bracket, a simple calculation of the distribution divided by 0.85 should be all it takes to yield thegross distribution required.Yet because of the provisional income test and the lack of itemized deductions,this calculation is anything but simple.
Wehave determined the percentage of federal tax on the distribution is 21.5%, 24.6%, 25.7%, and 26.2% respectively even though none exceeded the 15% bracket even after the distribution.Minnesota has a top tax bracket of 7.85% yet the rate on the distribution is 8.1%, 9%, 9.3% and 9.9% without the proposed increase to state taxes.
Because of the state and federal income taxes, a distribution of $3,000, $6,000, $9,000, and $12,000 respectively are required to net the $1,900, $3,800, $5,600 and $7,400 of property taxes for these couples.The complicated nature of the tax code is itself a crisis, yet a greater problem is that that 100% of these IRA distributions go to the payment of taxes in some form or fashion without any tax relief. Is this the reason for which you saved your money?
Making us pay taxes on income use to pay property tax is ruthless.Taxing social security benefits because of an IRA distribution is coldblooded.The solution to this dilemma will have to come in the form of a congressional act changing the tax code.I can think of $Trillions of reasons that Congress will not act to reduce taxes for retirees.Until the tax code changes, financial planning could provide some answers.
The rules of thumb and strategies we learned while accumulating are not effective or can even be harmful when retirement plan distributions begin.The scenario described above is just one of many potential scenarios regarding IRA distributions.Paying for a mortgage with IRA distributions may increase your taxes.Your charitable gifts may fatten the US Treasury rather than reduce your taxes.Expect to see your medical insurance and expenses and long-term care insurance deductions diminish once distributions are a part of retirement income.
Today's retirees need to find a way to get funds out of an IRA without paying excessive taxes.There is not a one size fits all solution for all taxpayers.A qualified fee-only advisor should review the cash flow, income taxes, assets, liabilities, and other personal circumstances of prospective clients.This is not as easy as it might seem. Most advisors use packaged financial planning products primarily designed to sell products.It took the author an enormous effort to develop a program that will determine both the tax on distributions and to compare the current and future cost or benefit of various strategies.At the risk of sounding self-serving, our clients as well as other advisors tell us they have not found a program that quantifies the value of financial advice in such a clear and concise way.
In my opinion, a qualified financial advisor cannot represent both the client and the insurance or investment companies of whose products they sell with out a conflict of interest.In this respect, an independent broker has a conflict of interest in the same way as a captive broker.The companies they represent pay both captive and independent brokers.A fee only advisor does not sell products or receive commissions or referral fees.If they receive compensation from any source other than the client, they are not a fee only advisor!
Roth IRAs are all the rage today.Many brokers and so-called advisors earn fat commissions by recommending a Roth IRA or Roth IRA conversions as a potential strategy to reduce future taxes.The concept is that government has promised us future tax-free distributions with a Roth IRA, if only we agree to pay our taxes now.It is true that the current tax code offers tax-free growth, income tax bracket, with absolutely no tax consequence for future distributions.Common sense tells us to switch from an IRA to a Roth IRA.After all, a promise is a promise.If you can't trust the federal government, whom can you trust?As for me, I plan to continue to monitor the tax system and to put some of my money in ordinary investment accounts that are not subject to the slippery distribution rules of the IRS.
About the author- Roger C. Kruse, ChFC, CFP(R) is a NAPFA registered FEE ONLY(R) financial advisor and a co-founder of Foundation Financial Planning dba FFP Wealth Management, a registered investment advisory firm with clients in many states. Roger is in his 20th year of investment management and comprehensive financial planning with a focus on the needs of retiring or retired clients. FFP Wealth Management 11375 Robinson Drive Suite 210 Coon Rapids, MN 55433 763-231-2760. Learn more at http://www.ffpwealthmanagement.com (c) 2008-2009 FFP Wealth Management