Retirement is just around the corner for a vast number of Baby Boomers. Perhaps you are among those who are counting the days until you retire and settle in nicely to live off of that well-planned portfolio in your IRAs, a pension and, of course, Social Security. Unfortunately, the time of reckoning arrives and the income taxes on the IRA funds must be paid as money is withdrawn from the account.
Taxes on IRA Funds
The federal government provided inducements for individuals to save for their own retirement in lieu of relying solely on Social Security payments. A certain amount of untaxed funds could be invested in an IRA with taxes due at the time of withdrawal. One premise behind the various forms of IRAs is that the money invested in an IRA would accumulate and compound at a faster rate than an equivalent non-IRA account because the dividends and interest would be sheltered from income taxes until the time of withdrawal.
A second premise of the IRA concept was that individuals would no longer be working at a regular salary and thus be in a lower tax bracket when funds would be withdrawn from the account. Except for the Roth IRA, IRA withdrawals are fully taxable as ordinary income in the year they are withdrawn.
Taxable Social Security Benefits
When Congress passed the Employee Retirement Income Security Act (ERISA) that established IRAs in 1974, Social Security benefits were not taxable income. It wasn’t until 1981 that Social Security benefits became taxable; today, up to 85% of Social Security benefits become taxable depending upon the amount of adjusted gross income reported on your federal tax return.
Impact on IRA Withdrawals
In order to meet a standard of living approximating that of pre-retirement days, individuals expect to withdraw tens of thousands of taxable dollars annually from IRAs. By doing so, they automatically exceed the limits for tax-free Social Security benefits. This means that taxable income is immediately increased by 85% of the Social Security benefits. This may bump you into a higher tax bracket and increase the percent of income tax paid on all income from 24% to 36%.
During retirement, many individuals will find that they are paying more in income taxes than they planned.
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