Beware the Retirement Triple Tax Trap!

Transcript:

Hey guys, Mike Frontera here with another Retirement Theory video. What if I told you that you could pay almost a 50% tax rate on your IRA withdrawals in retirement? “Pay almost half of my withdrawal back in taxes, sign me up!” Actually, you’d probably want to know how to avoid doing that. Well I’m going to show you how it happens so you don’t blindly step into what I call the Triple Tax Trap!

OK, the issue comes up because common sources of income, like Social Security and capital gains have different rules, rates and phase-ins versus regular income. And while these sources are taxed differently, they all impact each other.

So what’s the Triple Tax Trap? Well, the triple tax trap occurs when you have Social Security benefits and Capital gains that span more than one of their respective tax thresholds. And it actually happens at a surprisingly low level of income. It is the chain reaction of new taxable income coming in, which pushes more SS to become taxable, which pushes more capital gains to be taxed at a higher rate. It’s scary stuff, so if there are any small children are nearby, I might have them go in the other room for this part.

Alright you’re still with me, great! Let’s talk briefly about the different tax thresholds and then see one of these nearly 50% tax hits in real time!

Let’s start with SS-- there’s a calculation for SS taxation known as Provisional Income. I have other videos about how to calculate it, and it’s a fairly complex formula, but basically there are three thresholds. First is where all of you SS benefits are tax-free. Moving up, you’ll see the same benefits become 50% taxable, and finally as you move further, up to 85% of your benefits become taxable. As you move between these levels, you’ll experience all different levels of benefit taxation.

Next Capital Gains tax— these are special rates for the sale of capital assets (like stocks, bonds, mutual funds) held for more than 1 year. Here again, you have a portion where capital gains are tax-free, with this 0% rate, but then it jumps up to 15% and then 20%. There’s another potential Medicare tax in there but that isn’t part of this particular horror story.

Finally, we have our ordinary income tax brackets, which have seven different rates depending on how much you have coming in in income.

Now, something interesting happens when we get certain combinations of SS, ordinary income, and capital gains. Particularly where some, but not all the SS is 85% taxable and some, but not all of the capital gains are taxed at 15%. We have the chance of invoking…the triple tax trap!

Now when we get in this triple tax trap, the next dollar of income is not only taxable itself, but also pushes another dollar of SS to be 85% taxable, which pushes even more capital gains to be taxed at 15% as well.

So let’s take a look at this in action :

The really scary part is that how deceptively low your tax rate will look on the surface. Someone in a relatively low 12% Federal tax rate might think this would be a great opportunity for an IRA withdrawal, or maybe even complete a Roth conversion.

“Hey if I grab $1000 on my IRA I’m on the hook for $120 in tax. Not too shabby”

Well yes, that $1000 is taxed at 12%. So there’s your $120. But watch. That $1000 actually pushes $1000 more of your SS to be 85% includable in income. So we have to add in $850 more of income. So there’s another $102 in taxes AND now with our total income $1850 higher, another $1850 of your previously 0% rate Capital gains gets pushed into the 15% tax bracket for capital gains. So there’s another $277.50.

So let’s add up our total: $120 + $102 + 277.50 = $499.50 in taxes on our $1000 IRA withdrawal. That is a tax rate of 49.95%. Plus state taxes where applicable!

So that’s why it’s important to understand how income affects your entire tax picture, not necessarily just the tax on the income itself.

So, do you have questions for me? Come visit me at www.retirementtheory.com or send me an email at mike@retirementtheory.com. Did you click subscribe on this video or follow me on Facebook? I think that you should. You’ll continue to see videos like these on everything retirement planning. Once again, thank you for joining me, we’ll see you next time.

Sources:

1. https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2021

2. https://www.irs.gov/pub/irs-drop/rp-20-45.pdf

3. https://www.ssa.gov/planners/taxes.html

Clips Referenced:

1. Scooby Doo Ghost - https://www.youtube.com/watch?v=kZFPLyu3-D0

2. “Not too Shabby!” - https://www.youtube.com/watch?v=-2QfDzUwqu4

Note: Cambridge does not offer tax advice