You have likely heard of the marriage tax penalty before. But have you ever heard of the worker tax penalty? Recently I've become more and more impressed with how incredibly skewed our tax system is toward retirees, those approaching retirement, and of course those living off capital rather than labor. Is that right or wrong? I don't know that I even have an opinion on the topic (although I'm sure many do), but I can tell you this, learning the rules of the game and using them to my advantage helps me win in both Settlers of Catan and in life. Today, I'm just going to talk about the rules of the game. I'll leave it up to you at the ballot box to express your feelings about those rules.
Nine Ways Our Tax System Favors Retirees over Workers
# 1 No payroll taxes
Here's a big one. Earned income is subject to payroll taxes, like Social Security and Medicare tax. For me as a self-employed person, that totals up to 15.3% on my first $132,900 and 2.9% after that up to $250,000 at which point it climbs to 3.8% with the addition of PPACA tax. Granted half of SS and Medicare tax is deductible as a business expense, but it's still a ton of money. Don't think you're getting a break as an employee either. Your employer pays you less than they otherwise could because they are covering half of those taxes for you.
# 2 Social Security and Medicare Benefits
This one isn't technically a tax, it's a benefit. But in reality, they're all tied together. Our society has elected to redistribute income from young workers to older retirees. That primarily comes in the form of Social Security payments and Medicare benefits. Some think of these payments as social insurance for being part of society and others view them as pensions that are earned. However you prefer to look at them, the actual money that goes to the retirees comes from those working. Sure, you have to qualify for them, but who are we kidding? Forty quarters (10 years)? You had to work for 20% of your productive life to get those benefits? Not exactly a high bar. To make matters worse, the taxes are (mostly) not deductible for the workers and at least partially tax-free to the retirees. There are no taxes due on Medicare benefits and at most 85% of Social Security benefits are taxable.
# 3 Catch-up Contributions
This one isn't quite a benefit to retirees but is a benefit to those nearing retirement. Many of our best tax breaks are found in retirement and similar accounts. These accounts often have “catch-up contributions” as follows:
- 401(k) employee contribution: Extra $6,000 per year after age 50
- IRA contribution: Extra $1,000 per year after age 50
- HSA contribution: Extra $1,000 per year after age 55
These benefits provide additional tax breaks to near-retirees.
# 4 Higher Standard Deduction
In 2019, the standard deduction is $12,200 ($24,400 married filing jointly.) However, if you are blind or “aged” (i.e. 65+), that deduction is $13,800 ($27,000 MFJ).
# 5 Property tax breaks
Many states and counties provide a property tax break for the 65+ crowd too. In my county, if you are 65+ and have an income under $33,350, you get up to $1,015 off your property taxes. I suspect my county is pretty chintzy in this regard. Property tax benefits for seniors in California start at age 55 and are much more impressive. I suspect there is something available in most locations.
# 6 Basis Isn't Taxed
Here's another aspect of our tax laws that works out well for retirees. We tax income, not wealth. So if you sell something, you don't have to pay taxes on the amount of that sale up to the amount you paid for it. Add another $250,000 ($500,000 MFJ) in tax-free gains if that thing is the home you live in. While lots of people have crazy ideas about “never spending principal,” spending principal is incredibly tax-efficient.
# 7 Investment Related Tax Breaks
Retirees who invested in taxable accounts benefit from several other tax benefits. These include the lower long-term capital gains tax rate (often 0% for a typical retiree) and qualified dividend rates (also as low as 0%). Given the lower Adjusted Gross Income most retirees have, they may also no longer be paying PPACA related taxes. Depreciation and the 199A deduction also lowers taxes for those investing in real estate. Municipal bond interest can be federal and even state income tax free. Of course, none of this unearned income is subject to payroll taxes. Retirees are much more likely to have investments than workers and thus benefit more from these tax breaks.
# 8 The Tax-deferred Retirement Account Arbitrage
# 9 Elimination of Retirement Account Penalties
Taking money out of retirement accounts prior to age 59 1/2 (or an HSA prior to age 65) without paying a penalty requires jumping through a few hoops to make sure you have an exception to the rules (although to be fair, early retirement via the SEPP rule is an exception.) There are no such restrictions for those at typical retirement age.
As you can see, Uncle Sam wants you to retire. The earlier you do so, the lower your lifetime tax bill will be.
What do you think? What other tax benefits do the elderly and retired get? Comment below!
I prefer the original Catan. The expansions just add too many rules and make things more complicated.
It is amazing how a small change to the rules can dramatically change your strategy.
You don’t even have to be a retiree to take advantage of the tax arbitrage between W2 income and non-W2 income.
Passive income typically enjoys a lot more tax benefits as well. Qualified dividends will be at most taxed at 23.8% which is much more favorable than the 37% max tax rate on earned income.
I have written about my thoughts on social security and have likened it to a Ponzi scheme which as you mentioned the base of the pyramid is supported by the younger workforce to buy in and pay for benefits for the older generation. At one point there may not be enough base to support the top and reduced benefits and/or higher required contributions will have to be implemented.
I’m not sure “Ponzi Scheme” is accurate. I mean, everybody can see how Social Security works. It’s a tax on workers that pays non-workers a benefit. Nobody is being told they’re getting earnings on their principal when in reality they’re getting somebody else’s principal.
Small correction. It is 40 quarters for social security and Medicare qualification not 10. Also social security benefit is based on average of 35 highest years of working, so if you only work 10 years you get a smaller benefit (but the bend points means it won’t be a straight proration).
Medicare is either qualified or not. No reduction of benefit unless you are a high earning retiree you have to pay more
Thanks for the typo correction. 40 quarters/10 years. Absolutely.
Don’t forget huge benefits to non-earning spouses who never/rarely contributed payroll taxes – 50% of their spouses Social Security benefit + Medicare. Single/unmarried persons and dual working couples subsidize this greatly.
“While lots of people have crazy ideas about “never spending principal,” spending principal is incredibly tax-efficient.”
Great line.
I see this sentiment again and again, particularly from dividend-focused investors. If I were to spend $100 buy 10 shares of a $10 growth stock that pays no dividend, and later those 10 shares are worth $100 each, have I spent principal if I sell one share and am left with $900 worth of that stock?
Early retirees don’t get the age-related benefits you outline, but I counted four benefits above that anyone with low income can take advantage of, even with a substantial nest egg.
Cheers!
-PoF
Don’t get me wrong- I agree that there are a lot of favorable tax situations to being retired vs working, but the whole article seems to be written in a tone that makes it seem as if a system is unfairly structured to advantage/disadvantage one portion of the population based on a characteristic that can’t change- i.e. gender, race, etc. In fact, the expectation is that the vast majority of people will work and then retire, experiencing both tax paradigms in their lifetime. For instance, #8- that’s not really a benefit of being retired, it’s a benefit to you while you’re working that you get to take a big tax deduction, pay less in taxes, and then find a way to extract the contribution and earnings at a lower rate later. And in my own opinion, anyone living on less than $33k needs extra support as opposed to those that have higher incomes, whether on taxes of the property variety or otherwise.
Perhaps I’m just reacting to the fact that I didn’t sense as much gratitude in this article as I usually do in your writing. Perhaps just the way i’m reading it this morning…
You know, one of the challenges of being a financial blogger is coming up with a lot of different ways to say the same things- spend less than you earn, invest wisely, learn the tax code etc. Today, I took an angle you didn’t seem to like. Come back next week and perhaps it’ll be more to your liking.
I agree it’s easier to retire than change your race though. 🙂
Perhaps I shouldn’t be, but I’m always surprised by how much high earners complain about their tax rate. People use words and phrases like “fraud” and “Ponzi scheme” when talking about Social Security. People disparage government operations, when citizens like themselves literally elected such officials. Perhaps this was a miscommunication, but it sounded like some thought the world was going to end because of legislation regarding “stealth IRA’s.”
For us as workers far off from retirement, we understand how much taxes will cost us each year and plan accordingly. We know that an extra $1,500 direct deposit from a moonlighting shift is not actually the full amount we will keep. I don’t think this “reasonable” attitude is common among others. Its almost like many are just looking for an excuse to throw an online temper tantrum and be offended because there is simply a cost to having a social contract.
This isn’t a high income or low income thing. Just about everyone who pays taxes complains about them.
Therefore, please allow me the freedom of speech to complain a little.
Just to point out, I vote plenty against much of the spending that goes on by both Republicans and Democrats alike but unfortunately I’m outnumbered. I also did not sign any social contract that you speak of. So sure, I complain about my taxes. But, I am thankful I get to live and work in the US instead of Venezuela or some other dictatorship and gladly pay what I owe vs some other alternative. I’ll take “high” taxes and the US vs living somewhere else, any day of the week.
“I also did not sign any social contract you speak of.”
I’m sure you know what I mean. Social contract theory and government 101. I also don’t think that particular argument will hold up well if you happen to try to evade taxes…
Who is trying to evade taxes?
I just want the right to complain about them.
It was just a tip for you, since it sounded like you don’t understand some things about political theory. I’m afraid I don’t exactly understand what you’re getting at. Have fun complaining, then!
I see the favored tax rates for long-term capital gains as acknowledgement that part of the gain being taxed is really just inflation of the original capital. Almost all of the rest of the tax code is inflation indexed, so why should gains due merely to inflation be taxed? If one could inflate their basis before figuring capital gains tax, it might be reasonable to tax what’s left at ordinary income rates. Note that after inflation, the nominal gain might become a loss and so should be deductible.
Of course, calculating inflated basis for every sale would be a tax prep nightmare.
I agree. The other reason for a low LTCG rate is to encourage long term investment.
Huge benefits to non-earning spouses who never/rarely contributed payroll taxes – 50% of their spouses Social Security benefit + Medicare. Single/unmarried persons and dual working couples subsidize this greatly.
Agreed. Lots of people talk about the marriage tax penalty, but marriage is actually a tax (and as you point out Social Security) benefit, so long as one of the spouses isn’t working. For better or worse, the government is incentivizing a stay at home parent type model.
That stay at home parent incentive thing did not work out for us. My wife stayed home with the kids until they were in school (nine years), then went back to work. She wound up with a PIA within a couple bucks of half of mine. She will realize approximately nothing for all the SS (and Medicare) taxes she paid. There was a chance to get some of this back with a complicated SS claiming strategy, but they took that away. She still has a chance to get something for her taxes by claiming after full retirement age, but for that to pay off, we have to beat the actuarial tables.
It didn’t work out for you because she went back to work. The incentive was for her NOT to go back to work.
Several other benefits to her working – increased household income, $19k retirement plan contribution + employer matching, access to another income and health insurance source and not be dependent on single income, as her pay increases, so will her SS benefit. Non-monetary benefit of having a fulfilling career.
How do you respond to someone who thinks its unethical in early retirement to do IRA to roth conversions and tax gain/loss harvesting? Likewise to “manipulate” their income to get subsidies for Obamacare in early retirement?
Where do they draw the line? Are 401(k) contributions unethical? Is taking the mortgage interest deduction unethical?
Perhaps if the government stopped punishing me for working, then I wouldn’t early retire, and hence there would be no question, ethical or not.
Why respond to them at all? I guess the obvious answer is that ethics has nothing to do with legality; otherwise speeding would be unethical.
Love these low tax rates as Fla resident
18% effective tax rate on 300k of unearned income
I rather work and stay young and healthy, then to enjoy some lousy tax breaks, as I get closer to death. For those who think it is unfair for older folks to keep more of what they have earned, after having payed taxes for decades just as you are now, remember this. The grim reaper is the ultimate tax collector. Rumor has it, that he does not give any refunds. Uncle Sam, well he is a joke when compared to the ultimate tax collector.
Good point. I think I’d rather have 10 more healthy years than a few extra tax breaks!
I can think of a least one tax provision that goes the other way. Many workers are able to use pre-tax dollars for healthcare, both for out-of-pocket expense and insurance premiums. Retirees have to pay these expenses with after-tax dollars, and depending on your pre and post retirement tax brackets, and how much use you made of the pre-tax provision, the difference can be in the thousands of dollars per year.
Regardless, your informative post and the replies its generated are likely only a prelude to the coming inter-generational tension that is headed our way as people have fewer children and live longer. The actuarial assumptions behind social security and medicare are no longer valid. “Reforms” are inevitable, whether they involve reduced benefits, increased taxes, delayed eligibility or most likely, all of the above. I suspect younger workers will bear the brunt of it because of the growing number of retirees, and the percentage of the retirees who vote. It will be a triple whammy because to keep benefits unchanged for current retirees (a likely necessity in any political compromise) and provide even reduced benefits to future retirees, younger workers will likely pay a higher tax rate on more of their income, and have to work longer to be eligible for full retirement. Doesn’t sound fair, but seems like the likely outcome.
Good reason to have an HSA- then you can use it to pay for health care with pre-tax dollars.
I never knew about the increased standard deduction for aged folks – time to update the spreadsheets!