The $1,170 Mistake

| | Comments (0) | TrackBacks (0)

They thought they made a good financial decision. "Why not pay off the car and truck loan with our savings? We will be debt free, won't have to remember to make monthly payments and we'll avoid paying interest on those loans! After all, popular financial gurus advocate being debt free, how could we go wrong? "

 Had they used funds from a savings or checking account, cashed in a CD or taken a distribution from a Roth IRA to pay off these debts there wouldn't have been a problem and I wouldn't be writing this article. Instead this retired couple took a distribution from their tax-sheltered accounts (pensions, 401K or Traditional IRA's.) Upon taking the money from their accounts - the previously tax-sheltered funds were now subject to taxation.

 What follows is a brief explanation of income taxation for retirees. Add up all income excluding Social Security - interest, dividends, rental income, and distributions from IRA have and pensions etc. These are all "subject" to taxation. Continuing with our example - add up Social Security payments. Now add half of Social Security to other types of income. Any amount in excess of $32,000 is also subject to taxation. Up to 85% of social security benefits can be subject to taxation based on other income. From the amount that is subject to taxation - subtract $13,600 which is the standard deduction for a married filing jointly couple who are both aged 65 or older. Subtract another $7,300 which is for two personal exemptions. In other words, of the amount that is subject to taxation - the first $20,900 is tax-free - the remainder is your actual taxable income.

 For our couple under discussion, $9,200 was subject to 10% tax rate resulting in a federal income tax bill of $920. The distribution also increased their income that is used in calculating eligibility for Pennsylvania's Property Tax Rebate Program so they were not eligible for the $250 rebate they would have received had they not taken the large distribution. Added together the $920 and $250 equals a $1,170 mistake.

 As it turns out, the decision to become debt free was much more expensive than paying a few more months of interest. This might be considered a case of being penny wise and pound foolish.

 How can you avoid making a similar mistake? Become more familiar with various savings and investment vehicles and pay attention to how they are treated for tax purposes. Learn more about your personal income tax situation. Even if you pay someone to prepare your tax return, review it to understand how the calculations are performed. Think about putting money in taxable accounts like savings accounts, tax-deferred accounts such as IRA's and 401K's and tax-free accounts such as Roth IRA's (you pay taxes when you invest!) As you pay for expenses in retirement you can control to a certain extent how much tax you pay based on which accounts you draw your funds from.

0 TrackBacks

Listed below are links to blogs that reference this entry: The $1,170 Mistake.

TrackBack URL for this entry:

Leave a comment

February 2011

Sun Mon Tue Wed Thu Fri Sat
    1 2 3 4 5
6 7 8 9 10 11 12
13 14 15 16 17 18 19
20 21 22 23 24 25 26
27 28          

Recent Comments