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Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Thursday, April 4, 2013

Kaplan: Reforming the Taxation of Retirement Income

Richard L. Kaplan (Illinois), Reforming the Taxation of Retirement Income, 32 Va. Tax Rev. 327 (2012):

Legal and financial analyses abound about various means of saving for retirement and the tax advantages that they present, but very little attention has been paid to how retirement income is generated and the tax consequences that pertain to its generation. This article fills that void by examining the three major sources of retirement income: Social Security, employment-based retirement plans, and personal savings. For each of these sources, this article considers how retirement income is generated, sets forth the applicable federal income tax treatment, and proposes reforms to make the pertinent tax rules more sensible. Among its recommendations are simplifying how Social Security retirement benefits are taxed, bifurcating defined contribution plan withdrawals into capital gains and ordinary income components, repealing certain exceptions to the early distribution penalty, reducing the delayed distribution penalty and adjusting the age at which it is triggered, and changing the residential gain exclusion to avoid unanticipated problems with reverse mortgages.

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The paper's discussion of taxing Social Security benefits is flawed. First, the non-indexation of taxation thresholds was intentional. Its stated objective was to gradually expose all taxpayers to taxation of 50% (changed to 85% in 1993) of their benefits. Second, the argument that a 15% allowance for post-tax basis in benefits is dishonest. It may or may not still be true that scheduled (but unaffordable) payments return an average of 7 times the employee's original "contributions". But if you consider only those recipients above the taxability thresholds, this ratio is much, much lower.

By analogy, suppose the federal government gave each of the 50 states $1 billion under the condition that it be given equally to the residents of the state. Then suppose Congress said that each person now had taxable income of $50 billion divided by the country's total population. On average the math is correct. But populous state residents are overtaxed while residents of states with population are undertaxed on their windfall. That's the defective math for Social Security taxation: high earners lose once on the progressive benefit formula and a second time on taxation at unfairly high rate.

With modern computers it's entirely feasible to compute an accurate individual allowance for post-tax contributions just as for a private annuity. That's the fair way to proceed.

The paper has a novel discussion of how Section 121's lock-in effect also impairs utilization of reverse mortgages. I encourage more authors to look at Section 121. As real estate prices rebound we face a fundamentally unfair situation in which homeowners whose financial setbacks force them to sell are taxed very heavily on inflationary "gains", while much wealthier homeowners are able to hold the house until death and avoid any tax on the inflationary appreciation of the house.

Posted by: AMTbuff | Apr 5, 2013 1:27:18 PM