Meet the alternative minimum tax for the retired

Q: What triggers taxation of Social Security benefits and what does not? Can the tax be avoided? - L.M., by e-mail

A: The only proven way to avoid the tax is to have little or no income beyond Social Security benefits. I call this the Diabolical Tax. It affected very few people in 1983 when it became law, but it affects many people today. It will affect more tomorrow. Few of the lawmakers who passed the law, however, are still in office.

When the combination of your income from Social Security and other sources exceeds certain amounts, some of your Social Security benefits must be included in your taxable income. Not more than 85 percent of your Social Security benefits may be taxed.

About 30 percent of all Social Security recipients now pay some taxes on their benefits. The number of retirees paying this tax is rising rapidly because the basic formula is not indexed to inflation. Think of it as the Alternative Minimum Tax for the retired, snagging more retirees every year.

For a married couple, benefits begin to be taxed when income from other sources exceeds $32,000 less one-half of Social Security benefits. So a couple with $20,000 in benefits would start to have some of their Social Security benefits added to their taxable income when their income from dividends, interest, capital gains, pensions, work, rents and tax-free bonds exceeded $22,000.

For a single person, benefits begin to be taxed when income from other sources exceeds $25,000 less one-half of Social Security benefits. So a single person with $18,000 in benefits would have some of those benefits added to her taxable income when her income from other sources exceeded $16,000.

While income from tax-free bonds must be counted when calculating other income, Roth IRA withdrawals are not included. This is why I favor Roth IRA accounts for younger workers. Unfortunately, it is entirely possible that Congress could decide to make a portion of Roth IRA withdrawals part of the calculation at a future date. Remember, Social Security benefits were never supposed to be taxed, but today they are.

Many people confuse this tax with the reduction in Social Security benefits that can happen to those who take Social Security benefits before full retirement age but continue working. For 2008, for instance, wage earnings greater than $13,560 trigger a reduction in the Social Security benefit being received. (After reaching full retirement age, there is no limit on work earnings.)

Q: I purchased William Bernstein's "The Four Pillars of Investing" as you suggested in a recent article. While reading it, I became completely convinced an index fund is the way to go, which leads to a quick question. I currently have a taxable mutual fund (Franklin Templeton Founding Funds C shares) that has fairly high expenses. I would rather have these funds invested in the Vanguard 500 Index fund, but I am not sure if there is any negative consequence (transaction-wise) in doing this. The last purchase I made with my taxable fund was in May 2007. - C.H., by e-mail

A: The cost basis for your investment depends on when you bought the shares. If you purchased the shares long ago, for instance, you are likely to have a long list of shares owned. The largest number of shares will be the original purchase. After that, you'll have other shares that were acquired through reinvestment of either dividends, capital gains or both.

You should be able to get this information from the firm that holds your shares and sends you a monthly statement.

This fund, with an expense ratio of 1.83 percent, according to Morningstar.com, has got to be considered very expensive. It is considered to be a "moderate allocation" fund, which means it is about a 60/40 mixture of equities and fixed income.

For that reason, moving to an index fund that is 100 percent equity - like the Vanguard 500 Index - would not provide you with much relief - your risk of loss would increase, not decrease. To reduce expenses AND have similar risk you should move to moderate allocation index fund. That's why Vanguard Balanced Index (ticker: VBINX) is a better match. It has an expense ratio of only 0.19 percent.

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