Avoid the 'Tax Torpedo'

The term 'Tax Torpedo' invokes the image of an evil device designed to sink your retirement ship. Well, it exists! After-tax income is what really matters to a retiree and therefore taxation is a critical part of the equation on how to structure a financial plan to take retirement income. Unless you plan properly, you could easily find yourself paying over half of any increased income in taxes. On the other hand, if you do plan properly, you can send this torpedo back to the government by paying less tax! Let’s see how this works.

It is common for a retiree to take Social Security and fund any remaining income needs with IRA withdrawals. The IRA income is taxable at ordinary income tax rates.

Once this taxable income exceeds a certain amount, the Social Security benefit will also be taxed. This amount is called ‘Combined Income’ and is calculated according to an IRS formula. It depends on the mix of the taxable money and the Social Security benefit. If the Combined Income is below a threshold amount, there’s no tax on your benefit, but above the threshold, your Social Security benefit will be subject to taxation. That’s a big step up in your tax rate. Exceed another threshold and up to 85% of your benefit will be taxed. Most retirees don’t know how to calculate their Combined Income and are hit by the ‘Tax Torpedo’.

For example, if you are in the 25 percent tax bracket, you would pay 25 cents on an extra dollar withdrawn from your IRA account as ordinary income tax and then another 21.25 cents on the Social Security dollar now subject to taxation at 85 percent. The effective marginal tax rate on that extra IRA dollar is therefore 46.25 percent. State taxes will push the marginal tax rate to over 50 percent. The first Combined Income threshold is $32,000 for a married couple, and the second threshold is at $44,000. These are not indexed for inflation; so over time, more and more retirees will be subject to the 'Tax Torpedo'.

To avoid this fate, you need to adjust the mix of income types to lower this ‘Combined Income’ number.

One way to do this is to delay taking Social Security, which increases the benefit and means you need less taxable withdrawals to supplement your income. As a sole source of income for a married couple with the standard income tax deductions, Social Security is tax free.

Structure an IRA withdrawal strategy to provide income during the period from retirement to the delayed Social Security date of the primary worker. By taking withdrawals from the IRA, we reduce mandatory distributions after age 70 1/2, potentially keeping more Social Security benefits tax-free.

Finally, use money in a non-taxable Roth IRA, or in an after-tax savings or brokerage account, to reduce the need to withdraw taxable IRA money.

Bottom line, you need to pre-position the assets you will be spending down in retirement, so you can manage your taxable income and avoid the 'Tax Torpedo'.

To check if you are safe from this ugly fate, call (408) 725-7135 or click here.

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