Q & A

What can I do about the higher marginal tax rate I hit when I begin taking RMDs from by deferred income accounts?

Full Question: I have concerns about Social Security and my income taxes. By the time I turn 70, my 401(k) will likely be worth well over $2 million. When I turn 70½ and begin the mandatory withdrawals, my income will be large, and that will put me in a higher marginal tax rate. It will also make my Social Security taxable. The double whammy will basically wipe out the Social Security benefit for me.

I am confused about what I should do in the 15 years leading to my 70th birthday. I get the feeling that by the time I turn 70, the country will change the laws to completely take away Social Security checks because I will have that $2 million-plus. I am leaning toward taking benefits early, when I turn 62, rather than lose them in the future. This would help me let my 401(k) grow tax-free as much as possible. Taking Social Security early, however, seems against the advice of a lot of financial planners. Am I missing something?

Answer: You’re in a quandary, but it’s a quandary in a great ZIP code. Most retirees won’t face this problem because their only income will be Social Security. Still, it’s deeply vexing that the same two parties that voted for the legislation to create 401(k) plans with the Revenue Act of 1978 then voted to, in effect, tax the income coming from those plans in 1984. What most people don’t understand is that we don’t experience the taxation of benefits that way because it can be triggered only by having additional income from other sources — such as from a tax-deferred 401(k) account. It’s also a middle-class tax because it will be over and done well before your total income exceeds $100,000. For you, that’s the good news. While many readers need to figure out what money to use today to possibly limit the taxation of benefits tomorrow, you have enough assets that you can be certain your benefits will always be taxed, no matter what you do. What that means is that you need to add 85 percent of your Social Security benefits to your taxable income, pay the tax and get on with it.

SourceScott Burns, AssetBuilder Inc. – May 17, 2014

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