Look out for the Social Security tax torpedo. It may be heading toward the hull of your retirement accounts as we speak. And if it hits, you may not even realize it.
I’m in favor of taxing Social Security benefits, as the United States has done since 1983. I blogged this week against Donald Trump’s plan to stop that taxation.
But there is a problem with how it’s done. For middle-income taxpayers, different provisions of the tax code amplify one another. In certain circumstances, because of the tax torpedo and another twist nicknamed the capital gains bump zone, someone in the 12 percent tax bracket who takes a $1,000 retirement distribution could end up paying $499.50 in tax — for a marginal rate of nearly 50 percent.
There are ways to protect yourself from paying more tax than necessary, but they’re not simple. And you may not even know you could be doing better because no one tells you — least of all the Internal Revenue Service.
One of the people pointing out this problem is Wade Pfau, a retirement researcher who has a doctorate in economics from Princeton. In his “Retirement Planning Guidebook,” he calls the tax formula “loopy,” which he doesn’t mean as an insult. He means there’s literally a loop in the formulas: You don’t know your adjusted gross income until you know how much your Social Security will be taxed, “but you don’t know how much of your benefit is taxed until you know your A.G.I.,” he writes.
I talked to some other financial experts about the tax torpedo. Aaron Brask, an independent investment adviser in Lake Worth, Fla., called it “a very significant factor” for people whose annual retirement income is in the five-figure range. Brask is a former Wall Street quant with a doctorate in applied math, so he knows about complex calculations. “It’s virtually impossible for somebody to just work this out on the back of a piece of paper,” he said.
The tax torpedo is “nasty business,” Laurence Kotlikoff, an economist at Boston University who created MaxiFi financial planning software, told me.
Here’s the problem. The share of Social Security benefits that the government subjects to taxation depends on your provisional income, which is defined as your modified adjusted gross income plus half of your Social Security benefit, plus any tax-exempt interest. (That includes income from pensions, 401(k)s, savings accounts and so on. Modified A.G.I. is just A.G.I. with a few items added back and excluding the taxable portion of Social Security.)
Retirees can make their provisional income go up or down by changing how much they take each year in distributions from their retirement accounts.
For married couples filing jointly, Social Security benefits are untaxed if provisional income is under $32,000. Starting at that point, each additional dollar of provisional income causes another 50 cents of Social Security benefit to be taxable. And starting at $44,000, each additional dollar of provisional income causes another 85 cents of Social Security benefit to be taxable.
The tax torpedo is headed your way whenever the share of your Social Security benefit that’s taxable is greater than zero but less than 85 percent. In that middle range, an additional dollar of income triggers ordinary taxes on that income, plus the torpedo: a tax on an additional increment of your Social Security benefit, also at the ordinary tax rate. (If you’re a high-earner, you’re already paying tax on 85 percent of your benefits, so an additional dollar of income won’t trigger further taxation of those benefits.) Here’s a video by Brask that explains the phenomenon.
The Social Security Administration says that about 40 percent of recipients pay taxes on some portion of their benefits. Pfau told me about three-quarters of those are affected at least somewhat by the tax torpedo.
What can make matters worse is the capital gains bump zone. Here’s how that works: The I.R.S. taxes your capital gains at a rate that depends on your total income, not just the size of the gains. It’s as if the capital gains are stacked on top of ordinary income. So when your ordinary income goes up — possibly because of the Social Security tax torpedo — some portion of your long-term capital gains may be “bumped” out of the zero-tax bracket.
Let’s say you’re a single person in the 12 percent tax bracket with a decent Social Security benefit and some long-term capital gains, and you need to pull $1,000 out of your I.R.A. (This can affect joint filers to some degree as well, but let’s stick with this example.) First, of course, you pay $120 on that ordinary income. Second, the increase in your ordinary income pushes $1,000 of your capital gains, which are stacked on top of ordinary income, from the zero bracket into the 15 percent bracket. That’s another $150 in tax. Third, the $1,000 increase in your ordinary income exposes $850 more of your Social Security benefit to taxation as ordinary income at a rate of 12 percent, for $102 in tax. Fourth and mercifully last, the $850 increase in ordinary income from Social Security bumps an additional $850 of your capital gains into the 15 percent tax bracket, for another $127.50 in tax. Total tax: $499.50.
There are, by the way, similar spikes in marginal tax rates scattered through the tax code. For example, the earned-income tax credit phases out as people’s income rises, so the tax penalty for earning an extra dollar is higher than it might seem if you look only at the income tax rate. The tax torpedo and the bump zone stand out in that they affect a lot of middle-income people in retirement.
The tax torpedo would go away if everyone paid taxes on the same percentage of their Social Security benefits. But that would be more regressive than the current formula — hitting the poor harder than the rich. There’s no obvious fix, which is probably why it’s stayed basically this way for four decades.
One way to minimize the hit from the tax torpedo and the bump zone is to realize more of your taxable income before you collect Social Security. If you retire at, say, 62 and don’t start taking Social Security until age 70, the period in between is a good time to convert an ordinary, tax-deferred Individual Retirement Account or 401(k) into a Roth I.R.A. You’ll pay taxes on the money you put into the Roth, of course, but you’ll do it at your current relatively low tax rate, and then you won’t have to pay taxes later when you pull money out of the Roth. Plus you’ll avoid the tax on Social Security benefits, which you aren’t receiving yet.
“The time to act or strategize is before you turn on the Social Security,” Brask said. “There are not many do-over options.”
At the risk of making this too complicated, I’ll mention another tax trick I learned in researching this piece. Conventional wisdom says that you should hold off on spending down your Roth I.R.A.’s until you’ve used up all your other savings, so the money inside the Roth I.R.A.’s can continue to grow tax-free.
But you may actually want to save some taxable savings for your later years. The first dollars of your income aren’t taxed because they fall within the standard deduction. The taxable portion of your Social Security (and annuity income if you have it) might not completely use up your standard deduction. If you’ve already spent all your taxable savings, you’ll be letting room in the standard deduction go to waste. It’s a mistake that’s hard to spot, until it’s too late.
The tax code and the Social Security formulas are byzantine. I welcome ideas from readers on how to cope with their complexities — or better yet simplify them for all.
The Readers Write
Only time will tell whether David Rosenberg is right, and his views are certainly shared by many others. However, despite all of the supposed signals of an impending recession, the outlook for gross domestic product growth has remained positive. One month’s disappointment in the employment numbers does not a trend make. The U.S. economy remains near full employment. The stock market is not the economy.
Scott Boone
Pasadena, Calif.
I spent 40 years as a lawyer and the last 20 of them in the gas utility business. America has a permitting problem and if you are against Senator Joe Manchin’s bill then what you are really saying is that climate change isn’t enough of a risk to actually work across the aisle and get what you need while giving others what they need. In this divided country environmental purists are the greatest climate risk there is.
Would you wait four or eight or 12 more years to get the “ideal” solution and delay all of the capital expenditures needed for clean energy and waste the tremendous incentives in the Inflation Reduction Act because you wouldn’t let other industries also benefit from permitting reform? That’s a really dumb idea.
Gary Kruse
Allentown, Pa.
Quote of the Day
“Left-wing populists, such as the Five Stars movement in Italy, Jean-Luc Mélenchon in France, and Bernie Sanders in the United States, support climate action because they see such measures as necessary to rein in greedy corporations that use fossil fuels and pollute the environment to the detriment of ordinary people. By contrast, right-wing populists see climate policies as driven by transnational political elites who want to impose taxes and regulations no matter the burdens they place on working-class people.”
— Edoardo Campanella and Robert Lawrence, “The Populist Revolt Against Climate Policy,” Foreign Affairs (July 25)
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