Taxing retirement income is outdated

An expert on taxation at the University of Illinois has said that while many people in the country prepare for retirement, the tax consequences of retirement income for retirees are “outdated and simply inappropriate”. 

Law professor, Richard L. Kaplan, the Peer and Sarah Pedersen Professor at Illinois, said that very few people fully understand the consequences of tax income until they reach the age of retirement.

Kaplan said:

“Legal and financial analyses abound regarding the various means of saving for retirement and the tax advantages that each option presents, but very few people consider the tax consequences of that income until they’re in retirement.”

There are three main sources of retirement income:

  1. Personal savings
  2. Employment-based retirement plans
  3. Social Security

For each different source of retirement income Kaplan proposes several reforms to make pertinent tax rules more reasonable. He added that the proposals he made are intended “to remedy the persistent, but hardly benign, neglect that has characterized the taxation of retirement income.”

The proposals include:

  • Simplifying the taxation of Social Security retirement benefits
  • Splitting defined contribution plan withdrawals into ordinary income components and capital gains
  • Raising the age at which the delayed distribution penalty is triggered
  • Changing the residential gain exclusion to avoid reverse mortgage issues

Kaplan noted that the main source of retirement income is Social Security, yet the taxation on Social Security benefits is much more complicated than it should be.

Why is taxing retirement income so complicated?

“Because in addition to the progressivity that derives from a graduated income tax, it implements another degree of progressivity. As income increases, it exposes a larger proportion of benefits to taxation, and those amounts are then subjected to rising rates.”

Regardless of other income, a person reports Social Security benefits need to be made taxable to the same extent. 

Kaplan said:

“All Social Security benefits should be taxable, regardless of the recipient’s other income, subject to an exclusion of 12.4 percent to reflect the payroll taxes paid during the person’s working life. Higher-income recipients would still pay more in income tax on their benefits because their income puts them in a higher income tax bracket, but they would not be doubly affected by their non-Social Security income.”

Despite not being as widespread as Social Security, employment based plans, like the 401(k), are also a major source of income during retirement. However, more than 90 percent of retirees withdraw all their retirement savings in one lump-sum distribution.

Kaplan said that there are reasons for this kind of behavior:

“Some retirees want to sever any remaining connections to a prior employer, while others want more diverse investment options than are available in the former employer’s retirement plan. Still other retirees prefer to buy nonretirement assets such as a second home or a new business, or pay down accumulated debts.”

However, according to Kaplan, taxing a lump-sum distribution should be divided into the original investment and the profit components. This ensures that the benefit of lower capital gains can be obtained on the investment profits.

He said that it is not a very radical proposal. “Until the Tax Reform Act of 1986, lump-sum distributions were eligible for long-term capital gains treatment on the amount that represented pre-1974 accumulations. And computerized recordkeeping in those days was not as ubiquitous as it is today.”

Kaplan noted that some elderly people may own a home that has gone up in value, but face one problem by making a reverse mortgage to supplement their retirement income less appealing.

Kaplan concluded:

“Some combination of homeowner age and longevity of ownership could entitle the person to exclude all gain upon sale of the home. In effect, no tax would be due upon the home’s disposition if the older homeowner has satisfied the stipulated criteria.”