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? Ten quarters? 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
# 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
Another big benefit for retirees is that they can usually withdraw money from 401(k)s, 403(b)s, 457(b)s, DBPs, and IRAs at a rate lower than the tax break they were given when they contributed. I mean, that was one of the main reasons to contribute.
# 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!