Retirees – Beware Of Double Taxation On Retirement Plan Distributions
Retirees – Beware Of Double Taxation On Retirement Plan Distributions
Social security benefits are exempt from income taxes if there is no other income to report. However, benefits are means tested by a complicated calculation called “the provisional income test.” This test is used to determine the portion of social security that is added to the taxable income. Quite basically, the more income you have the more taxes you will have to pay on your social security benefits. Some say that the test is so complex that it requires an advanced degree in mathematics to calculate!
For example, a retired couple with $24,000 of annual social security benefits and pension income of $20,000 per year would not be subject to tax on social security. Based on this information the taxpayer falls in the 10% federal tax bracket. This might lead them to assume IRA withdrawals are taxed at 10%. Logical, but not likely!
For example, assume the above taxpayer decides to buy a car for $25,000 and pay cash. They distribute $27,500 from their IRA, $25,000 for the car and $2,500 withheld for taxes. They believe that they have their taxes covered, wouldn’t you?
When they prepare their tax return they found that they still owe a whopping $3,400 of federal taxes! Their federal tax liability was $5,950 instead of the estimated $2,500. These are smart people; how could their estimate be so far off?
A review showed that the provisional income test converted $17,475 of their tax free social security benefit into taxable income. In other words, the taxable IRA withdrawal of $27k also forced them to pay taxes on over $17k social security. Doesn’t this sound like double taxation? This problem is further compounded if the couple takes an IRA distribution to pay the taxes, which in itself is taxable.
Would you believe that in some cases, planning can make more money than making more money can make you? Had this taxpayer done some planning before taking the distribution they may have found a way to reduce taxes. By spreading the cost of the car over three “tax years” they could have shaved over $8,000 off of their taxable income. By beginning with a December distribution, three “tax years” can be completed in as little as 13 months!
The personal finances of every household are different. One family might benefit from a single large distribution and the next could be better off to spread the distributions over several years. By taking a close look at cash flow, income taxes, net worth and goals (CING™) a comprehensive financial plan could illustrate ways retirees could save money on taxes without taking any risk. Be sure to plan retirement distributions in advance to identify strategies that could help to avoid double taxation, increase net spendable cash flow and provide financial peace of mind.
Roger C. Kruse, ChFC, CFP® is a NAPFA registered FEE ONLY® financial advisor and a principal and co-founder of FFP Wealth Management http://www.ffpwealthmanagement.com a registered investment advisory firm located in Coon Rapids, Minnesota. Roger has over 17 years of comprehensive financial planning experience with a focus on the investment and financial planning needs of retiring or retired clients. FFP Wealth Management has approximately $70 million of client assets under management. Go to their website for more information on retirement planning