Social Security benefits used to be exempt from taxation, but a significant shift occurred in 1983. During that year, Congress made the decision to impose taxes on a portion of benefits for individuals with the highest incomes. Fortunately, there are strategies to mitigate the impact of this tax burden, particularly if you plan your finances wisely.
At that time, only a small fraction—less than 10%—of beneficiaries were impacted by this change. Regrettably, lawmakers overlooked the necessity of adjusting the law to accommodate inflation. Consequently, today, the majority of Social Security beneficiaries find themselves obligated to pay federal income tax on a portion of their benefits.
Understanding Social Security Taxation
For couples who file a joint tax return, having a combined income falling between $32,000 and $44,000 can lead to up to 50% of their benefits being subject to taxation. If the combined income exceeds this range, as much as 85% of the benefits might become taxable. Single filers may find up to 50% of their benefits taxed when their combined income ranges from $25,000 to $34,000, and any income above that could lead to up to 85% of benefits becoming taxable.
How is Social Security taxation calculated?
Social Security taxes are computed based on your annual “combined income,” which encompasses:
- Your adjusted gross income, encompassing earnings, investment income, withdrawals from retirement plans, and other taxable sources of income.
- Any nontaxable interest you receive, such as interest earned from municipal bonds.
- Half of your Social Security benefits.
It’s important to note that individuals who solely rely on Social Security for their income are exempt from paying income taxes on their benefits. However, even a relatively modest amount of additional income can trigger the taxation of Social Security benefits.
The distinctive way Social Security benefits are subject to taxation can trigger what experts refer to as the “tax torpedo” – a sudden surge in marginal tax rates followed by a subsequent decline. This concept is explained by William Reichenstein, professor emeritus at Baylor University and co-author of “Social Security Strategies: How to Optimize Retirement Benefits.” Marginal tax rates represent the amount you owe on each additional dollar of taxable income you earn.
Due to this tax torpedo phenomenon, many households with middle incomes may confront marginal tax rates that are 50% to 85% higher than their regular tax brackets, as highlighted by Reichenstein.
To mitigate these effects, Reichenstein suggests that moderate-income households should consider delaying the initiation of Social Security benefits for as long as possible. By doing so and drawing funds from retirement accounts in the interim, individuals not only receive larger Social Security payments but could also potentially save hundreds or even thousands of dollars annually in taxes.
For those in the federal tax brackets of 10% to 22%, seeking advice from a tax professional or financial planner regarding strategies to alleviate the potential tax burden is advisable.
What is the tax torpedo phenomenon?
The “tax torpedo” is a phenomenon in tax planning, particularly relevant to retirement income, where the marginal tax rate paid on income exceeds the statutory tax rate. This mainly occurs due to the manner in which Social Security benefits are taxed, resulting in a higher effective tax rate on other income sources such as withdrawals from retirement accounts.
In the United States, the taxation of Social Security benefits is based on a calculation known as “provisional” or “combined” income. This is essentially half of your Social Security benefit plus your other gross income and any tax-exempt interest. If your provisional income exceeds certain thresholds, a portion of your Social Security benefits becomes taxable. For single filers with provisional income between $25,000 and $34,000 (or $32,000 to $44,000 for joint filers), up to 50% of benefits are taxable. If your provisional income is more than $34,000 ($44,000 for joint filers), then up to 85% of your benefits are taxable.
The “tax torpedo” arises when additional income causes more of your Social Security benefits to become taxable, leading to a higher marginal tax rate. This marginal rate then decreases at higher income levels, which may seem counterintuitive given the progressive nature of the tax system.
Consider Making Contributions to a Roth Account
Incorporating a Roth IRA or Roth 401(k) into your retirement savings strategy can be a beneficial step toward reducing the tax impact on your Social Security benefits. It’s important to note that you need earned income to contribute to a retirement account. Diversifying your retirement savings early in your career, well before your retirement years. Relying solely on a pretax retirement option could result in substantial tax liabilities down the road.
Once you reach the age of 70 1/2, you have the opportunity to engage in qualified charitable distributions, which involve making charitable donations directly from your IRA to a charity. This withdrawal remains untaxed and does not factor into your combined income, provided the funds are directly transferred from the IRA custodian to the charitable organization. You can make charitable transfers of up to $100,000 in this manner.
If you have reached the age at which required minimum distributions (RMDs) from retirement accounts must commence – currently set at age 73 – these qualified charitable distributions can be counted as your RMD, offering a tax-efficient way to support charitable causes.
Explore Alternative Approaches to Minimize Mandatory Distributions
For diligent savers, mandatory required minimum distributions (RMDs) can have unwelcome consequences, such as pushing them into higher tax brackets and elevating Social Security taxes.
Taking steps to access your retirement funds prior to being compelled to do so could be a sensible strategy. Another option worth considering is a Roth conversion, as suggested by Sarenski. During a conversion, funds are transferred from a pretax retirement account, like an IRA or 401(k), to a Roth IRA. While conversions typically incur taxes, the advantage lies in enjoying tax-free withdrawals during retirement.
However, it is crucial to consult with a tax professional or financial planner before making any decisions. Prematurely tapping into retirement accounts can lead to unnecessary taxes, increased Medicare or Affordable Care Act premiums, and other financial ramifications, such as the risk of depleting your savings prematurely. The key objective is to establish a balanced approach to tax rates, ensuring consistency rather than experiencing fluctuating tax rates between years, such as paying at 40% in some years and nothing in others.