Taxes in retirement

As you go through life, you will encounter several "life-changing" moments.  Some are good, such as graduating college or having a child, while others are bad, such as losing a parent or going through a divorce.  These moments can also bring changes to your financial life, including how much tax you owe and how it is paid.  

This article addresses taxes in retirement.  I realize this is not chronologically accurate, but it is an issue that several people are not prepared for when they enter retirement.  

Income and deductions

A retired taxpayer will likely have very different income and deductions than they had earlier in life, maybe even than the year before.  Their wage income will be replaced by distributions from retirement plans, investment income and Social Security.  Personal exemptions for children and mortgage interest will be replaced by charitable contributions and medical expenses.  Changes in income and deductions must be considered when determining how much tax will be owed each year.

Social Security

There's no easy way to say it: if you have other sources of income, up to 85% of the gross Social Security benefits you receive are taxable.   This often comes as a surprise to retired taxpayers, because there is often no tax withholding against this income.  However, you can elect to have Federal withholding taken from your SS benefits if you don't want to change the withholding on your retirement distributions.  Fortunately, SS benefits are not taxed in several states.

Paying taxes

The most challenging part of determining taxes in retirement is determining your income from all sources and electing tax withholding to cover all of it (or pay estimated taxes).  If you are taking distributions from a retirement plan, they will give you the option to withhold taxes on that distribution.  But, this withholding will be based on that distribution alone, and most likely will not cover investment income or Social Security benefits.  The key is to set your withholding high enough to cover taxes on all of your income, not just one source.  

In all, it is important for individuals that are nearing or entering retirement to meet with their tax advisor to determine tax implications of retirement.  Your tax advisor will consider changes in your income and deductions and advise on how much to withhold from retirement distributions or quarterly estimated tax payments that need to be made.  

Op Ed: A Millenial's View of Social Security

Social security is a pyramid scheme.  Bigger than Enron and Madoff and the calling cards Michael Scott was selling on The Office.  

I preface this by saying everyone that pays into the Social Security system (SS) deserves to benefit from those contributions at some point.  Receiving a SS check each month is evidence that you spent a long career working hard and you are benefiting from a system you paid into.  You can Google "social security benefits" and find hundreds of articles on when to start drawing SS, how spousal benefits work, and how much more you can get if you don't start drawing until 68 instead of 65.  These people are at the  "top of the pyramid".  But what about those of us at the bottom of the pyramid, looking up and wondering what will be left if we ever get to the top?  

SS was passed by Congress and signed into law by President Roosevelt in August 1935.  This was a part of a nationwide recovery after the Great Crash and depression in the late 20's and early 30's.  A complete history of SS can be found at the SSA website (in case you forgot it all from high school history like I did).  

In general, the program was designed to help older Americans that had lost all of their savings.  Almost 80 years later, the program is still in existence.  The program is funded through FICA taxes, which are withheld from an employee's paycheck at a rate of 6.2% and then matched by the employer.  Once an employee's wages reach a certain threshold ($117,000 for 2014) they are no longer subject to the FICA tax (Medicare never phases out, and is a whole other debate for another time).  

The problem is, every dollar a 30 year old worker puts into the system is paying benefits for someone in their 60s and 70s, hence the "pyramid".  The result is my kids will be paying the benefits for my parents, leaving my grandkids to pay for my benefits.  Furthermore, the SS system is heavily underfunded, meaning that it projects to have greater liabilities in the future than expected assets/income.  This is why you will hear some politicians suggest raising the minimum age when Americans can begin to draw SS benefits - so as to delay the number of new people signing up for benefits a little bit further down the road.  

In a perfect world, I would like the option to not contribute to the SS system, and also bypass the future benefits.  I have been educated on retirement accounts and insurance and understand my responsibility for myself and family in retirement.  Unfortunately that is not feasible for a variety of reasons, mainly being that if I quit contributing to the system, they will not be able to meet their current liabilities.  You can't do away with the program, because It would be impossible to draw a line in time and say "everyone from this age and older gets it, and everyone younger doesn't get it".  You also can't apply income limits, because the higher wage earning Americans pay more into the system through the FICA taxes.  

Absent any major overhauls, the greatest looming problem in my opinion, especially for Millenials, is that eventually the government will have to find a way to rectify the deficit in the SS program.  According to the 2014 Trustees Report, SS and Medicare payments accounted for 41% of all Federal expenditures in fiscal year 2013.  Since these benefits are set in stone and will increase as more baby boomers hit retirement, the only way to fix the deficit is to raise revenue i.e. some form of taxation.  It could be in the form of higher FICA rates which would affect take-home pay, or it could be in the form of a special "other tax" like the net investment income tax that is designed to siphon tax revenue from a specific group of taxpayers.  

If you are currently drawing SS or will be drawing it in the next 10 years - thank you for your years of hard work contributing to our economy.  You deserve the benefits from the system you paid into, and I will gladly pay in so that you can reap the rewards of your long career.  But I'm not counting on anything for me because in the next 35 years someone will figure out that the system is broken and unsustainable.  And I'm not sure my grandkids will be as willing to foot the bill as I am.

Idea$ 2014 - June: Tax-efficient investments

Taxpayers are always looking for ways to accomplish the wealth trifecta - preserve principal, generate income, and minimize taxes.  Yet accomplishing this feat is very challenging due to a number of external factors.  In order to preserve principal, investors must often sacrifice higher returns for less risky investments, which reduces income.  Riskier investments have the potential to generate higher returns (income), but they also present the risk of loss of capital.  Furthermore, investments that generate income subject the investor to a higher tax rate.  As you can see, it's easy to find investments that meet 2 out of 3 of these criteria, but winning the trifecta is much more difficult.  Following are some alternatives for taxpayers looking for tax-efficient investments.  

Municipal bonds

Municipal bonds (muni's) are tax-efficient in that the income they generate is typically not taxable at the Federal level and, if planned correctly, at the state level.  Muni's are bond issues for municipalities such as cities, counties or school districts.  Muni's, like all bonds, are sold at a premium or a discount depending on the bond's yield at the time of sale.  

Interest on municipal bonds is always tax-exempt at the Federal level.  Each state is different, but in Arkansas, all interest earned on Arkansas municipal bonds is tax-exempt to Arkansas.  For example, an Arkansas taxpayer with municipal bond interest from school districts in Arkansas and Texas will only pay Arkansas tax on the interest from the Texas school districts.  

Beware that tax-exempt income is a preference item for the alternative minimum tax.  Investors considering substantial investments in tax-exempt bonds should consult their tax adviser to verify that the interest will not subject them to the AMT.  

Master limited partnerships

Master limited partnerships (MLPs) have gained popularity in recent years for their favorable tax treatment.  Investors enter into MLPs as a partner.  During the year, they receive distributions from the partnership that are not taxable.  Then, at the end of the year, the investor receives a Form K-1 reporting their share of income and losses.  

Although it is possible for the K-1 to report income to the partner, due to non-cash expense items the distributions typically exceed the amount of income on the K-1.  The downside to owning units in an MLP is that, upon sale, a portion of the gain (if any) is reported as ordinary income.  See additional information regarding investing in MLPs in a previous article regarding owning MLPs in a retirement account.  

Practical considerations

Tax-efficient investing is best suited for investors that desire to preserve principal in their investments and also do not have many deductions to offset their taxable income.  A young taxpayer with children at home, dependent care expenses and a mortgage can afford to generate more investment income because their effective tax rate will be lower as a result of their deductions.  However, a taxpayer with no children and few deductions will benefit more from tax-efficient investing.  

Idea$ 2014 - February: Retirement accounts

During the month of January, it seemed as if everyday I went to the mailbox or checked my email, there was some kind of document related to my finances waiting for me.  On Monday I got a 1099 from my bank for interest earned during the year.  On Tuesday American Express sent me my "Annual Summary" which shows how much money I spent during the year and in what categories (which can be a great tool to use when making a Budget).  Then on Wednesday, I got my W-2, Thursday brought my 1098 mortgage statement, and on Friday I got a Form 5498 showing contributions to my Roth IRA.  The irony is, the 5498 also discloses the fair market value of the account at the end of the year, to which I responded "hmm, I figured it would be more than that....I wonder what I still own in there?"  

Between packing up holiday decorations and getting together tax information, retirement accounts don't carry as much priority this time of year.  But, this is a great time to go over your retirement accounts and analyze contribution amounts and investment allocations.  

Investment allocations

The investment allocation of your retirement portfolio is simply how you have your portfolio diversified between different types of investments.  There is a wide array of investment options out there, including common stocks and exchange traded funds (ETFs), to mutual funds and bonds.  There are even different allocations within some of these families.  For example, a mutual fund can own large-cap growth stocks or small-cap international stocks.  Determining how to allocate your retirement portfolio between these different types of investments is usually tied to your age.  A 30-year-old worker will want to have their portfolio allocated more to higher-risk investments like growth and international stocks, whereas a 60-year-old worker will want to have more of their portfolio invested in less risky assets such as dividend stocks or bonds.  This is true for two reasons: 1) as an older worker nears retirement, their risk of loss of principal is greater because they will be withdrawing the funds in the near future, and 2) an older worker does not have as much time to make up for losses in a broad market decline as compared to a younger worker.  A simple Google search will produce a number of links to investment allocation calculators where you can input your age, how long until you retire, and the amount you expect to contribute, and the calculator will suggest an investment allocation for you.  One of my favorites is from CNN Money, and can be found here.

Contributions

Another aspect of a retirement account to consider is how much to contribute.  The common response to this is 10% of gross wages, but that figure is debatable given certain circumstances.  First, a young worker might not be able to contribute 10% because they have other liabilities such as student or car loans that must be serviced.  A young worker just starting out, living on their own and providing for themselves might also not have the cash flow to put away 10%.  In this case the worker should put away something that they are comfortable with.  On the other hand, take an older worker (55) that makes a very high wage, let's say $250,000/year.  The 2014 contribution limits to a 401(k) are $17,500, and workers over the age of 50 can defer an additional $5,500 as catch-up contributions.  In this case, if the older worker put away 10%, they would exceed the allowable amount of contributions.  One other consideration is the employer match.  If your employer matches all contributions made by the employee up to 3% of their income, then it is beneficial for the worker to defer at least 3%.  This way, the worker will be saving something, and will be getting full benefit from their employer.  The match is in effect free money and should not be passed up.    

Company stock

I live in Little Rock, and we have a handful of publicly traded companies located here, one of which is Windstream Communications.  Dividend investors love Windstream because, even with a stock price below $10, they pay a $1 per share annual dividend.  This is a pretty good return, especially on common stock.  But every once in a while I will hear a friend of mine that works at Windstream say "I dumped all of my 401(k) into Windstream stock...can't beat that dividend!"  Although this mindset seems smart, ("I work there, it's a great company, and it's a great dividend) it is a very risky move.  Several employees at Enron did the same thing, and ended up with no retirement savings after the company went belly-up.  I'm in no way suggesting that Windstream will have a similar fate, but the lesson is investing all of your retirement account in one asset, including company stock, is very risky.  The key to having a retirement account that grows and can weather the ups and downs of the market is diversification, and investing all of your contributions in one asset prevents even the smallest form of diversification.  

In conclusion, take some time this month to look over your retirement account statement.  Calculate how much you have invested in each asset class, and if there is too much or too little consider rebalancing the account.  Because the assets are in a retirement account, you won't be taxed on any gains or losses generated transferring funds between investments.  During this process, consider how much you have invested in stock of the company where you work, and take some off the table if it seems too high.  Also look at your contributions and see if they are too high or too low.  If you find yourself having excess funds each month, it might be wise to up your contributions, but if you are struggling to make ends meet or have other obligations it's okay to lower the contributions, as long as you don't sacrifice your company's matching provision in the process.  

What is myRA?

After President Obama's State of the Union address this past week, there has been quite a buzz about "myRA" accounts.  More details were released in a press release from the White House the following day.  But, with 401(k)'s, 403(b)'s, and IRA's already in existence, why do we need another retirement savings vehicle?

In simple terms, the myRA is essentially a Roth IRA offered by an employer that has very low initial investment requirements and where the principal is guaranteed.  Here's how it would work in practice: an employer that does not currently have a plan in place can offer a myRA to their employees.  The employees make after-tax contributions to the account, as low as $5 to $25.  These contributions are deposited to the same government securities investment fund that only federal employees had access to before, meaning the principal is backed by the US Treasury.  The employer has no cost because they will not administer or contribute to the accounts.  

Married couples making up to $191,000/year and single individuals making up to $129,000/year can contribute to a myRA account.  Fittingly, these are the same income limits to make contributions to a Roth IRA for 2014.  Another catch is that the account only exists for a finite amount of time - the earlier of when contributions reach $15,000, or 30 years.  Once these are reached, the account holder will be required to roll their money to a "private sector retirement account", i.e. a real IRA.  

The pros of this approach are 1) employees that work somewhere without a retirement plan now will have an option, 2) contributions are guaranteed by the US government, which eliminates the majority of the investment risk, and 3) with very low initial investments, people in middle and lower income brackets will find it easier to participate.  The cons are, well, only one: the 1-year return on the government securities investment fund last year was 1.47%.  

The President has urged the Treasury to start making these accounts available to the public by December 31, 2014.