How One Widow Paid $9,623 in Tax While Another Widow Paid $0

As we discussed in the previous chapter, if a married couple’s provisional income is less than $32k they pay no tax on their Social Security benefits. However, for a single taxpayer, if provisional income is greater than $34k then up to 85% of his/her Social Security benefit will be subject to tax.

Let’s say you are a single taxpayer and have a $30,000 distribution from a Traditional IRA in addition to your $30,000 of Social Security benefits. In this case your provisional income is $45,000. You will pay tax on your Social Security Benefits.

Remember: Provisional Income is half your Social Security benefit plus any other income you receive (Roth distributions excluded).

Now say that $30,000 IRA distribution came from a Roth. In this case your provisional income is only $15,000 because Roth IRAs are not included in the calculations. So, you pay NO TAX!

They each have $60,000 of income, $30,000 from Social Security and $30,000 from IRAs. Judy’s IRA income is from a Traditional but Jane’s is from a Roth.

By having a Traditional IRA, Judy has to pay $3,476 in tax. Jane pays nothing. Over the course of 10 years Judy will pay nearly $35,000 more in federal income tax than Jane. Since most state income taxes are based on taxable income calculated for a federal return, the figure may be even higher.

Just think about what you could do with an extra $3,476 each year. That could be the premiums for your Long Term Care Insurance policy or it could be your car payment, Medicare premiums, etc.

But Wait There’s More!

Ever since John died, Judy has wanted to take her daughter on a month-long cruise vacation. “No time like the present,” she said. So, she takes an IRA distribution of $50k to pay for the cruise. Much fun was had.

But smiles turn to frowns when Judy gets a call from her tax guy the following year. She owes almost $10,000 in federal income taxes! Nearly $7,000 more than the year before even though she only increased her gross income by $20,000.

Her income went up by $20k, a 33% increase. But her taxes went up nearly $7k, a 250% increase!

Judy is stunned to learn that by taking out $20,000 more from her IRA she raised her taxes by $6,146, which is an effective 32% rate.

I can hear you asking, “Wait a second! She’s in the 22% tax bracket. How is her effective tax on this distribution 32%? This seems fishy!”

Indeed, it IS fishy! But it is reality.

She is being taxed twice on the same income. Those IRA distributions are subject to income tax but it also made more of her Social Security benefits taxed as well. When Judy only had a $30,000 IRA distribution just $13,850 of her Social Security benefit was taxable.

But now with the $50,000 IRA distribution, her taxable Social Security benefit jumped to to $25,500. Her total total taxable income more than doubled from $30,550 last year to $63,500.

A 33% increase in gross income caused a 100% increase in taxable income. A better example of double taxation you won’t find.

How the Roth Saves the Day…Once Again

Now, let’s look at Jane. She also increased her income by $50,000 to take her daughter on that same 30-day cruise. But Jane has a Roth IRA, not a Traditional.

What happened to her taxes??? Nothing. She NETS $80,000 and she still pays no tax. Her provisional income is still under the threshold for her Social Security benefit to remain tax free. No tax on Social Security, no tax on Roth = no tax due.

I know there are disbelievers among you. So, follow the steps below to see exactly why Jane pays no tax.

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