The Tax on Your Retirement Savings
A special income tax is hidden among the instructions on your Federal form 1040. If you are younger than retirement age, you would have no reason to notice it at all. It is found on line 20 of the long Federal tax form, identified as “Social Security benefits.”
You don’t get Social Security benefits yet? Learn about this tax now, before it hits you - hard. Every dollar you put away into tax-sheltered savings (except Roth IRA contributions) will one day pay this tax. This tax is a classic of political stealth and deception.
Line 20 does not tax Social Security benefits, since these benefits are not taxable. Instead, this special tax falls on other income you receive after you begin receiving Social Security benefits. This tax changes your gross income, and that is what changes your tax rate when you receive money from a retirement account.
The tax increase is not small. It jumps up your marginal tax rate by 50 percent. So if you are in the 15 percent tax bracket, your marginal tax rate becomes 22.5 percent. And if you are already in the 25 percent tax bracket, it can raise your marginal tax rate by 85 percent: instead of paying 25 percent tax to the IRS for what you get from an IRA or 401(k) plan, you will pay 46.25 percent on this money.
Imagine two twins, both with identical jobs and incomes. But let’s say one twin saves lots of money and the second twin spends everything. Assume that each twin receives identical Social Security benefits, but the first also receives distributions from a 401(k) plan he contributed to, and never paid taxes for, his entire life. Taxes will be due when the retirement distributions begin. If the second twin keeps on working, because he has no savings, his marginal tax rate will be perhaps 15 percent. But the retirement distributions from the first twin will have a tax rate of 22.5 percent on every dollar. If the twins were in the 25 percent tax bracket, the frugal, prudent twin would pay 46.25 percent on every dollar.
Only professional income tax preparers, and members of Congress, are aware of how this tax works (only a few Congressional staff understand it). For a chilling look at how it is calculated, check out the instructions and the worksheets that come along with Line 20. You’ll find a masterpiece of confusion.
This tax was first passed in 1983. In those days, Social Security was headed for bankruptcy by 1990, so a tax increase was the solution Senator Bob Dole and Alan Greenspan, not yet chairman of the Federal Reserve, decided to give us. They knew it would be political dynamite to change anything about Social Security, so they crafted this sneaky idea. Social Security would not be touched! Instead, other income you get in retirement would be taxed at a higher rate.
To delay any visible effects of this tax for at least 10 years, a large $25,000 exemption was granted ($32,000 for married couples filing joint tax returns). But the exemption was not indexed for inflation. Congress did that on purpose, so eventually everyone would come under this special tax - but not until the culprit members of Congress had retired. A quarter century has passed and this tax now affects the savings of almost every retired American. In a few years all but the poorest retired people will pay this extra tax.
Last year, Congress passed amendments to the 401(k) law to enroll all American workers automatically, and a special retirement savings credit, form 8880, has been part of the tax code for the past four years. It is as if Congress knows raising taxes directly is unpopular, so they design schemes to collect more revenue indirectly from people’s tax-sheltered retirement savings. Young people who are encouraged to save for retirement are being suckered (only the Roth IRA escapes this tax).
Is your plan for retirement to give the federal tax collector half of what you’ve saved? The only good news in this story is that California state income tax does not have this higher rate feature. The tax systems in Arizona and about 40 other States do include this extra tax, automatically incorporating it in your “adjusted gross income.”
The lesson to be learned from this sneaky tax on retirement savings should be to toss out the entire tax code and replace it with a federal system of simple, flat-rate State taxes (see my book on this site). It is treacherously undemocratic for any tax system to be as incomprehensible as the one in the United States today.
March 28th, 2007 at 6:57 pm
I would like to add your “Tax On Your Retirement Savings,” to my blog. I find it very informative and could be very useful in my organizing. Thank You. Rudy
Joe: Thanks for the kind remarks, Rudy. Yes, you can add it and I hope others do the same.
October 17th, 2007 at 11:59 am
The Smart Money web site has a good explanation of the formula and also has a tax calculator that might be interesting to readers who want to see how this tax on retirement savings affects them.