Watch out for the Social Security tax torpedo. It could possibly be heading for the hull of your retirement accounts right this moment. And when it hits, you may not even notice.
I’m in favor of taxing social advantages because the United States has done since 1983. I blogged this week against Donald Trump’s plan to abolish this tax.
But the best way it really works is problematic. For middle-income taxpayers, various provisions of the tax code reinforce one another. Under certain circumstances, someone within the 12 percent tax bracket who receives a $1,000 retirement payout could find yourself paying $499.50 in taxes—a marginal tax rate of nearly 50 percent—due to tax torpedo rule and one other twist called the capital gains bump zone.
There are ways to guard yourself from paying more taxes than you must, but they don’t seem to be easy. And you could not even know you may be doing higher because nobody tells you – least of all of the IRS.
One of the people stating this problem is Wade Pfau, a pension researcher who holds a PhD in economics from Princeton. In his “Guide to Retirement Planning”, He calls the tax formula “bonkers,” which he does not imply as an insult. He means there’s literally a loop within the formulas: You do not know your adjusted gross income until how much of your Social Security advantages are taxed, “but you don’t know how much of your benefits are taxed until you know your AGI,” he writes.
I spoke to a couple of other financial experts in regards to the tax torpedo. Aaron Brask, an independent investment adviser in Lake Worth, Florida, called it “a very significant factor” for people whose annual retirement income is within the five-figure range. Brask is a former Wall Street quant with a PhD in applied mathematics, so he’s aware of complex calculations. “It’s virtually impossible for someone to just calculate that on the back of a piece of paper,” he said.
The tax torpedo is a “nasty deal,” Laurence Kotlikoff, an economist at Boston University who developed the financial planning software MaxiFi, told me.
Herein lies the issue. The portion of Social Security advantages that the federal government taxes is determined by your provisional income, which is defined as your modified adjusted gross income plus half of your Social Security profit plus tax-free interest. (This includes income from pensions, 401(k)s, savings accounts, etc. Modified AGI is just AGI with some items added and excluding the taxable portion of Social Security.)
Retirees can increase or decrease their provisional income by changing the quantity of annual distributions from their retirement account.
For married couples filing a joint tax return, Social Security advantages are tax-free if provisional income is below $32,000. At that time, each additional dollar of provisional income causes a further 50 cents of the Social Security profit to be taxable. And starting at $44,000, each additional dollar of provisional income causes a further 85 cents of the Social Security profit to be taxable.
The tax torpedo hits you every time the taxable portion of your Social Security profit is bigger than zero but lower than 85 percent. In this middle range, a further dollar of income triggers normal taxation of that income, plus the torpedo: a tax on a further increase in your Social Security profit, also at the traditional tax rate. (If you are a top earner, you already pay taxes on 85 percent of your advantages, so a further dollar of income doesn’t trigger further taxation of those advantages.) Here is a video by Brask, who explains the phenomenon.
According to the Social Security Administration, about 40 percent of recipients may have to pay taxes on some portion of their advantages. Pfau told me that about three-quarters of them are at the very least partially affected by the tax torpedo.
What could make matters worse is the so-called “bump zone” for capital gains. Here’s how it really works: The IRS taxes your capital gains at a rate that is determined by your total income, not only the quantity of gains. It’s as if capital gains were added to atypical income. So in case your atypical income goes up — perhaps due to Social Security tax bump — a few of your long-term capital gains will be “pushed out” of the zero tax bracket.
Let’s say you are single and within the 12 percent tax bracket, have a good Social Security profit and a few long-term capital gains, and want to withdraw $1,000 out of your IRA (this may increasingly apply to those filing jointly to some extent, but let’s follow this instance). First, you may obviously pay $120 on that atypical income. Second, increasing your atypical income pushes $1,000 of your capital gains, that are added to atypical income, from the zero bracket into the 15 percent bracket. That’s one other $150 in taxes. Third, increasing your atypical income by $1,000 causes $850 of your Social Security profit to be taxed as atypical income at a 12% rate, which suggests $102 in taxes. Fourth, and fortunately last, increasing your atypical Social Security income by $850 pushes one other $850 of your capital gains into the 15 percent tax bracket, meaning one other $127.50 in taxes. Total tax: $499.50.
By the best way, there are similar Peak marginal tax rates spread throughout the tax code. For example, the earned income tax credit is phased out as people’s incomes rise, so the tax penalty for an additional dollar is higher than it might sound when looking only on the income tax rate. The tax torpedo and bump zone are notable for affecting many middle-income people in retirement.
The tax torpedo would disappear if everyone paid the identical percentage of their Social Security advantages in taxes. But that may be much more regressive than the present formula – it could hit the poor harder than the wealthy. There is not any obvious solution, and that’s probably why things have remained essentially the identical for 4 many years.
One method to minimize the impact of the tax torpedo and bump zone is to appreciate more of your taxable income before you begin taking Social Security advantages. For example, if you happen to retire at 62 and do not start taking Social Security advantages until you are 70, the time in between is a very good time to convert an everyday, tax-free individual retirement account or 401(k) right into a Roth IRA. You’ll pay taxes on the cash you set into the Roth, in fact, but you may achieve this at your current, relatively low tax rate, and then you definately won’t should pay taxes later once you withdraw money from the Roth. Plus, you may avoid paying taxes on Social Security advantages you do not yet receive.
“The right time to act or develop a strategy is before you get Social Security involved,” Brask said. “There aren’t many opportunities to do this again.”
At the chance of over-complicating things, I’ll mention one other tax trick I learned while researching this text. Conventional wisdom says it’s best to wait to spend your Roth IRA until you’ve got exhausted all your other savings so the cash within the Roth IRAs can proceed to grow tax-free.
But you could actually want to avoid wasting some taxable savings in your later years. The first few dollars of your income are usually not taxed because they fall under the usual deduction. The taxable portion of your Social Security (and retirement income, if you have got it) may not fully use up your standard deduction. If you’ve got already spent all your taxable savings, you are leaving the wiggle room in the usual deduction unused. That’s a mistake that is hard to identify until it’s too late.
Tax law and social security formulas are complicated. I welcome ideas from readers on the best way to cope with their complexity – or, higher yet, the best way to simplify it for everybody.
Readers write
Only time will tell if David Rosenberg is correct, and his views are surely shared by many others. However, despite all of the supposed signs of a looming recession, the outlook for gross domestic product growth has remained positive. One month of disappointing employment numbers doesn’t make a trend. The U.S. economy stays near full employment. The stock market shouldn’t be the economy.
Scott Boone
Pasadena, California.
I’ve worked as a lawyer for 40 years and the last 20 of those have been within the gas utility industry. America has a permitting problem and if you happen to oppose Senator Joe Manchin’s bill, what you are actually saying is that climate change is not that big of a risk, that you may actually work across party lines and get what you wish while giving others what they need. In this divided country, environmental purists are the largest climate risk there may be.
Would you wait one other 4, eight, or twelve years for the “ideal” solution, and postpone all of the investments needed for clean energy and waste the big incentives of the Inflation Reduction Act because you do not need to permit other industries to learn from permitting reform? That’s a very silly idea.
Gary Kruse
Allentown, Pennsylvania.
Quote of the day
“Left-wing populists like the Five Star Movement in Italy, Jean-Luc Mélenchon in France and Bernie Sanders in the US support climate action because they believe it is necessary to rein in greedy corporations that use fossil fuels and pollute the environment to the detriment of ordinary people. Right-wing populists, on the other hand, believe that climate policy is driven by transnational political elites who want to impose taxes and regulations, no matter what burdens they impose on the working class.”
— Edoardo Campanella and Robert Lawrence, “The Populist Revolt Against Climate Policy,” Foreign Affairs (July 25)
