Do you want to avoid—or at least defer— taxation of your Social Security benefits?
William Reichenstein, a professor of investments at Baylor University, has a solution.
Don’t take your Social Security benefits ASAP.
Delay. Delay as long as you can.
That way you’ll have no taxation of benefits now. Use some of your retirement stash to provide spending cash now. That way you’ll have lower required minimum distributions later. So you’ll probably pay fewer taxes on your Social Security benefits when you take them.
Wait! Please, don’t leave the room.
Not a rich guy problem.
This is not a rich guy problem. This is something millions of people with modest savings face.
Today, many retirees are surprised when they complete their tax returns. They discover they owe more taxes than they thought.
How much more? It all depends. If you weren’t a saver, no problem. You’re just poor. But if you saved some, well, that’s different.
This tax doesn’t happen because you have money to burn.
It happens because you aren’t destitute.
The people paying the tax have some income from other sources. Just like they were supposed to have. Income from those IRA and 401(k) accounts that promised retiring to lower tax rates.
Getting hit by the Tax Torpedo
Writing in the June issue of the Journal of Financial Planning, Reichenstein and his co-researcher William Meyer laid out the implications of the tax torpedo (a phrase I used to characterize the problem in a 2003 column).
Here are some examples from their paper:
Tom, a single guy with $12,000 in Social Security benefits, has income from other sources. Enough income to bring his MAGI (Modified Adjusted Gross Income— don’t ask) to between $19,000 and $21,750.
So while he is in the 10 percent tax bracket, the tax on his Social Security benefits brings his marginal tax rate to 15 percent. (The marginal rate is the tax rate you pay on the last dollar of income. Since additional income from other sources is what triggers the tax on Social Security benefits, the marginal tax rate on that additional income is 15 percent, not 10 percent.)
But wait. We’re not done with Tom.
If his income from other sources brings his MAGI to anything from $21,750 to $28,000 his tax bracket is 12 percent, but the taxation of benefits increases the effective tax rate to 18 percent.
Reichenstein and Meyer call him Tom, but his real name could be John Everyman. His Social Security benefit is close to average.
Now see what happens to Jane, a single retiree
In another example, the two researchers demonstrate that you can have a quite un-spectacular retirement income and still pay income taxes at a higher marginal tax rate than the highest income earners in the country.
Jane, a single retiree with $30,000 in Social Security benefits, hits a marginal tax rate of 40.7 percent when her MAGI is between $34,568 and $43,707. Under the new tax law the highest tax rate is 37 percent. It is payable by singles with incomes over $500,000. To pay it on a joint return you’ll need income over $600,000.
This is not a sick joke. You can test it out for yourself by using the retirement tax calculator on the smartassets.com website.
The case of Fall Guy
Suppose our single friend Fall Guy has $17,000 in Social Security benefits and $22,000 in other income. According to the website, his federal income tax will be $1,340. But if he takes another $1,000 from his retirement account his tax bill will rise to $1,520. That’s an increase of $180. This means he is paying taxes at an 18 percent rate on that last $1,000.
If his Social Security benefits were not taxed, his tax bill would be $1,130, a significant $390 less, or nearly 26 percent lower.
There are two reasons this is a tax to hate.
The first is that it’s a clever form of taxation without representation. The formula for the taxation of benefits isn’t indexed to inflation. Almost everything else is. So while only 3 percent of retirees were expected to pay the tax back in the 1980s, an ever-rising number of people will pay the tax in the future.
The tax was passed by a truly bipartisan vote.
The tax does little for Social Security
The second is that it is a significant tax increase for many retirees, but the revenue does little for the financial future of Social Security. According to the most recent reportfrom the Social Security Trustees, the total income from the taxation of benefits was $37.9 billion.
That’s only 4 percent of the $956.6 billion in total revenue. It’s only 4.3 percent of the $877 billion in employment tax contributions.
Bottom line?
Mark Twain was being factual, not cynical, when he said,
“There is no distinctly native American criminal class except Congress.”
On the web:
William Reichenstein and William Meyer, “Understanding the Tax Torpedo and Its Implications for Various Retirees”, Journal of Financial Planning, July 2018 https://www.onefpa.org/journal/Pages/JUL18-Understanding-the-Tax-Torpedo-and-Its-Implications-for-Various-Retirees.aspx
Sunday, February 11, 2003 How the Tax Torpedo Hits
Sunday, July 8, 2016 The Tax Torpedo and the Middle Class
Smart Assets Retirement Tax Calculator https://smartasset.com/retirement/retirement-taxes
Social Security Trustees Report, Table III.A.3 https://www.ssa.gov/OACT/TR/2018/III_A_cyoper.html#990519
This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
Photo source: Pixabay.com
(c) Scott Burns, 2018