Tax rates increase for many at retirement

Save now so you can pay lots of taxes after you retire

By SCOTT BURNS / The Dallas Morning News

You don't have to be rich to look like a fat cat. To the Internal Revenue Service, you just have to be old and middle class.

While a working couple will pay taxes at a top rate of 38.6 percent if their taxable income exceeds $307,050, senior citizens can pay at rates of 40.5 percent and 50 percent even though their income is a fraction of that amount. For seniors who file as singles, the threshold incomes for these high rates are $25,000 and $34,000; for joint returns, the threshold incomes are $32,000 and $44,000.

The villain here is a bit of tax code from 1983. It provides for the taxation of Social Security benefits. If your income other than Social Security is modest, you won't have a problem. But if your income from other sources exceeds certain levels, the tax works so that each dollar of additional income is taxed for itself and also causes 50 cents (or 85 cents) of your Social Security benefits to be taxed.

In effect, this makes the marginal tax rate on your non-Social Security income 40.5 percent or 50 percent. This is the sort of levy Republicans decry as a crushing weight on the enterprising spirit. Neither party, however, thinks it is too much of a burden if you are collecting Social Security benefits.

This tax rate, by the way, is one of the reasons I regularly urge those approaching retirement to eliminate all mortgage and other debt – because taking withdrawals from 401(k) plans and IRA rollovers to make regular monthly payments can increase income enough to trigger this pernicious tax.

The only good news about this tax: Below a certain level, you don't pay it. Above a certain level, you don't pay it either. Like a punishing gantlet, the beating eventually ends – but only if your income is large enough.

Ironically, this tax may be the only real "compact between generations." Those who are saving for retirement will hate this tax even more than those who are already retired.
Why? Young workers will hate it because it will have a larger impact on their lives. While most of our tax code is indexed so inflation doesn't slowly float us all into higher tax brackets, this item is fixed. Since 1983 inflation has run at a 3.2 percent compound annual rate, causing the dollar to lose 45 percent of its purchasing power. As a result, more retirees pay the tax each year.
Unless Congress changes the law, it eventually will be nearly universal.

And that's the rub.

A study by economists Laurence J. Kotlikoff, Jagadeesh Gokhale and Todd Neumann, "Does Participating in a 401(k) Raise Your Lifetime Taxes?," shows that those saving today will suffer perverse effects. The more they save in 401(k) plans, the more their lifetime taxes will rise. Since their lifetime taxes are higher, their lifetime consumption will decline. There is, in other words, no benefit for saving.
The study uses a complex model that deals with a number of tax impacts – current versus future rates, possible lost deductions for home mortgage interest and taxes, etc. – but the largest single factor is the constantly declining real threshold for the taxation of Social Security benefits. (Readers can get a copy of the complete study by visiting Dr. Kotlikoff's Web page, http://econ.bu.edu/kotlikoff.)

Our friends in Congress, in other words, are perfect "crazy-makers" – people who give painful and contradictory messages. While they have resisted a move to repeal at least part of the taxation of Social Security benefits, the same crew proudly passed last year's major expansion of how much we can save in what they bill as tax-benefited accounts, the Economic Growth and Tax Relief Reconciliation Act of 2001.

Workers 50 and older will be able to save $12,000 in 401(k) and similar plans this year, rising to $20,000 by 2006. Workers under 50 will be able to save $11,000 this year, rising to $15,000 in 2006. The limits on IRA and Roth IRA plans were also increased. Basically, we're being urged to save more (and consume less) today so Washington can collect more taxes tomorrow.

A little sanity would go a long way when it comes to taxes. Unfortunately, Washington is looking more and more like an asylum.

Questions of general interest will be answered in future columns. Write Scott Burns, The Dallas Morning News, P.O. Box 655237, Dallas, Texas 75265, or send an e-mail. Check www.scottburns.com.

Scott Burns Questions about personal finance and investments may be sent to: Scott Burns, The Dallas Morning News, P.O. Box 655237, Dallas 75265; faxed to (214)-977-8776; or e-mailed to sburns@dallasnews.com. Questions of general interest will be answered in future columns.

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