The 401(k) Plan Tax Trap

Here’s a situation they don’t tell you about.

You’re 61 years old. You’ve had a good career, working for the same company for more than 30 years. You’ve also enjoyed a good income, regularly earning just over the Social Security wage base maximum. This year, for instance, you’ll earn $90,000— enough that your spouse hasn’t worked for years. Saving in the company 401k plan, which provides no employer match, isn’t difficult.

In fact, you’ve participated for years, to the exclusion of all other savings, and now have $180,000 in the plan— two years of income.

Query: If you intend to retire at age 62, should you continue saving in the 401(k) plan?

Answer: No. You should accumulate cash in a taxable account. If you don’t, you’ll be paying taxes at a 50 percent rate even though the top tax rate is supposed to be 38.5 percent.

How can this happen?

Easy. Your other income triggers the taxation of Social Security benefits.

At age 62 you’ll be eligible for $1,412 a month in Social Security benefits. Your spouse, who is the same age, will be eligible for $706 a month.[i] That’s a total of $2,118 a month—$25,416 a year.

Although your corporate pension will be reduced to reflect retirement at 62, your long years of service will bring it to $33,600.[ii]  As a consequence, your cash income— without any withdrawals from your 401(k) account— will total $59,016 a year. That’s nearly 66 percent of your final salary.

While financial planners commonly suggest that most people need about 85 percent of their pre-retirement income when they retire, a regular project at Georgia State University calculates that retirees with relatively high income need just 70 percent of their pre-retirement income due to the large decline in their tax burden.

Unfortunately, that 70 percent doesn’t include the $1,000 monthly medical insurance premium you’ll be paying when you are 62, 63, and 64— until Medicare kicks in at 65. That’s $12,000 a year that you’ll have to pay for three years.

The issue is how to get it.

Your federal income tax on $59,016 a year will be $3,424. That’s a lot lower than the taxes you paid while you worked. But if you take $12,000 from your rollover account, your tax bill will rise to $7,033, an increase of $3,609. As a consequence, you’ll only have $8,391 to pay the premiums

You’ll need to withdraw more.

So you take an additional $5,000.

Unfortunately, your income tax bill increases another $2,281 to $9,314. Your top income tax rate now appears to be 45.6 percent. As a consequence of rising tax rates, you’ve taken $17,000 from your IRA account and your income tax bill has increased $5,890, leaving you with $11,110.

You’re still short $890.

So you withdraw another $2,000 from your trusty IRA rollover. Your income tax bill rises to $9,854, an increase of $540. Suddenly your tax rate is 27 percent again and you’ve withdrawn more money than you need— you’ve got $12,570 after additional income taxes of $6,430. That’s just $570 more than the $12,000 you need to pay the premium.

What actually happened? Your withdrawals were taxed at rates from 27 percent to 50 percent and back down to 27 percent. More than $5,000 of your withdrawals were taxed at a 50 percent rate. Although your total cash income has never exceeded $78,000— an income usually taxed at 27 percent— you’ve paid income taxes at rates higher than people with incomes well over $300,000 a year. Here’s what your tax bill looks like as you withdraw each additional $1,000.

Welcome to the Tax Torpedo.

How do you avoid it?

For some people, it won’t be possible. If every dime you have is in a qualified account such as a 401(k) or IRA rollover, every dollar removed will be taxable income. It will cause more of your social security benefits to be taxed.

That’s not a good deal.

If you are in the 27 percent tax bracket and tax defer $1 dollar of income you are deferring $0.73 in purchasing power. If you withdraw it the following year and pay taxes at a 50 percent rate, you’ll be recovering $0.50 in purchasing power. Basically, your qualified plan will work to convert 73 cents into 50 cents!

To avoid that experience, near retirees need to have money in a taxable or Roth IRA account to keep their taxable income from hitting the 50 percent tax bracket. In this particular example, the early retiree can withdraw $10,000 a year from his 401(k) and remain in the 27 percent tax bracket. The additional $5,000 he’ll need to pay his medical insurance premium, however, will have to come from a taxable or Roth IRA account.

He’ll need to do that for 3 years.

Whatever he does, he will eventually pay some income taxes at a 50 percent rate.

Why?  When he turns 70 ½ he must start Required Minimum Withdrawals. In this example, the minimum withdrawal rate will take him into the 50 percent tax bracket.

Does this mean you shouldn’t participate in a qualified plan?

No. It means workers with higher than average incomes need to have a retirement assets in a variety of “pockets”— qualified plans, Roth IRAs, and taxable accounts— to avoid or minimize the tax traps set by our friends in Congress.

The new Bush administration savings and retirement account proposals will help make that possible.

[i] Based on figures from www.ssa.gov/OACT/COLA/exampleMax.html

[ii] This reflects a 5-year trailing average salary of $84,000, a typical pension crediting rate of 1.5 percent of salary per year of service, 33 years of service, and a 20 percent reduction to reflect early retirement. ($84,000 x (1.5×33) x .80)=$33,600.

Photo: by Nataliya Vaitkevich from Pexels

(c) A. M. Universal, 2003