The Tax Cuts and Jobs Act does represent a relatively significant tax cut for most middle-income retirees, but the bill did nothing to change the interactions between different income sources in retirement, which means that retirees will need to pay close attention to which accounts they withdraw from at which points in time.
To illustrate the interactions between ordinary income, such as IRA withdrawals, Social Security benefits and long-term capital gains, we’ll introduce a fictional couple—John and Jane Smith. Like many middle-income retirees, John and Jane do not have mortgage interest to deduct, and their state and local taxes are not enough by themselves to overcome the standard deduction in either the old system or the new.
John and Jane have $60,000 of combined Social Security income, $15,000 of long-term capital gains from their brokerage accounts and $45,000 of IRA withdrawals.
Their standard deduction under the old system for 2018 would have been $13,000, plus an additional deduction of $2500 because they are both over age 65, plus two personal exemptions of $4,150 each for a total of $23,800 of exemptions and deductions. The new tax system would give them a total standard deduction of $24,000 plus an additional deduction of $2500 because they are both over age 65 for a total deduction of $26,500.
Under the old tax system, if all brackets had been advanced to 2018, John and Jane would pay federal income tax of $9,577. Under the new tax system, the same couple would pay $7,461 in 2018. This represents a 22 percent tax cut for a couple, that in most areas of the country, would be considered upper-middle income.
Under the old tax system, if this couple would withdraw an extra $5,000 from an IRA, they would lose 55.5 percent of it to Federal income tax, paying an additional $2,775. Under the new tax rules, they would pay an additional $2,497.50 in Federal income tax, or 49.95 percent.
The rates this couple would pay on the additional withdrawals may seem absurdly high to you. Looking at the tax tables that will be posted all over the internet, the couple’s total income of $120,000 should put them no higher than the 25 percent bracket in the old system, or 22 percent in the new, even without considering that the maximum taxable portion of a Social Security benefit is 85 cents of each dollar.
It’s important to remember that if a taxpayer has only Social Security benefits and no other income, those benefits will flow to the taxpayer tax free. Social Security benefits only become taxable in the presence of other income. Whether or not a Social Security benefit is treated as taxable income depends on the total amount of other income on the return, which includes IRA withdrawals, capital gains and even otherwise non-taxable municipal bond interest. A more complete explanation of this tax treatment lives here. Similarly, someone whose income, including long-term capital gains, does not exceed the 15 percent bracket in the old system and roughly the 12 percent bracket in the new, would pay a 0 percent rate on long-term capital gains or qualified dividends. Only to the extent taxable income (including the capital gain or dividend) exceeds $77,200 plus any deductions, the 15 percent long-term capital gains rate is applied.
So how did we get to a 55.5 percent effective tax rate on the additional withdrawal under the old system and a 49.95 percent rate in the new?
The $5,000 withdrawal triggered ordinary income tax at 15 percent, creating $750 of federal income tax. In turn, this caused $4,250 of the Social Security benefit to become taxable as ordinary income, creating additional tax of $637.50. The combined $9,250 of additional taxable income pushed $9,250 of capital gains out of the 0 percent bracket and into the 15 percent bracket, creating an additional $1,387.50 of federal income tax. In sum, withdrawing the extra $5,000 from the IRA triggered additional tax of $2,775.
Under the new tax system, a very similar dynamic would occur. A $5,000 withdrawal would trigger ordinary income at 12 percent, creating $600 of additional tax. The withdrawal would cause $4,250 of Social Security benefits to become taxable also at 12 percent, for another $510 of tax, which would push $9,250 of capital gain out of the 0 percent bracket and into the 15 percent bracket for additional tax of $1,387.50. In sum, the extra $5,000 withdrawal triggered additional tax of $2,497.50.
This case study should illustrate that, although the stated goal of the Tax Cuts and Jobs act was to deliver tax savings while simplifying the tax code, retirees who have multiple streams of income should be highly aware that making smart decisions about which income streams to use at which points in retirement can still have a massive impact on their total tax bill. Further, the interactions between the different types of income streams for middle income people is not where most tax professionals make their money. They make their money on their bigger corporate clients who will all have significant questions as the bill creates significantly greater change for corporations and self-employed people, so find a financial planner who understands and has equipped themselves with tools to help you make sense of the changing tax landscape.
Joe Elsasser, CFP, RHU, REBC, is president of Covisum, a company that provides software for advisors and financial institutions.
Editor's Note: This article's original headline used the word "Create" instead of "Eliminate" and gave the wrong impression about the article's topic.