Your IRA, 401(k) and pension can be a time bomb when you retire

The best plan is to pay taxes first and invest in a Roth IRA for a potential savings of thousands of dollars

Jim Jorgensen

Your financial advisor will tell you “save for retirement and take a fat tax deduction. Why pay taxes on money you save for retirement?”

The answer is that for the past three years, Congress has been working on a “need” basis on the taxes you pay and the benefits you receive. For example, on the job:

  • This year, the amount of your payroll tax for Medicare is based on your income on the job.
  • Next year, your payroll tax for Social Security could be based on your income on the job.

This is an example of taxes on a “need” basis. The reason is that the more income you earn on the job the more you can afford to pay in payroll taxes. Of course, the benefits you collect in retirement are the same for any level of taxes.

Now for the elephant in the room no one in Congress talks about. Once retired, every dollar you take from your IRA,401(k) or other tax-qualified retirement plan increases your taxable income. For most people, this taxable income could cost you around $4,000 a year in taxes on your Social Security retirement check – something Roth IRA investors never pay.

Now consider affluence testing. The Social Security Commission Report said: Social Security benefits should begin to be reduced if family taxable income exceeds $40,000 with reductions reaching 85 percent if family income exceeds $120,000.

Let’s face it: on a “need” basis, Warren Buffett does not need a check, nor does Bill Gates, but anyone who saves by delaying taxes with a IRA, 401(k), 403(b) or other plans has taxable income in retirement and could face a sizeable cut in the monthly retirement check.

This is a classic case of wealth transfer. On one hand, an individual pays taxes based on a higher income in retirement (from cashing in their IRAs 401(k)s, pensions) but receives no benefits, while the other pays few taxes and receives a full retirement benefit check. But the sinister thing about this wealth transfer program is that the thresholds of taxable income in retirement that determines the size of your retirement check can change anytime.

So how does this work? Each year the IRS tells Social Security your taxable income. That sets your payroll deductions for Medicare and Social Security, and one retired your monthly Medicare premium is deducted from your Social Security check. That is based on taxable income in retirement, which could boost the monthly Medicare premium as much as 75 percent or more.

Everyone agrees that the Social Security System must cut costs to stay alive, but increasing the age of retirement or reducing the monthly retirement benefit check for everyone is a vote no one in Congress wants to make. But denying part of a retirement check for someone with hefty taxable income in retirement makes affluence testing the smart play to save the system.

What can you do? The best plan is to pay your taxes first and invest in a Roth IRA. Despite what you’ve been told, paying taxes first is a winner that can save you tens of thousands of dollars depending on the number of years you are retired.

Jim Jorgensen is the author of eight books by major publishers on retirement and investing. His new book is Retire Tax Free and he is also president of Retire Tax Free LLC, and with a Vancouver office provides small business with tax free retirement and benefit plans. To reach him, call 360.326.3593.