Dodge the Social Security Tax Torpedo and Save More

dodge the social security tax torpedo and save more.jpg Business

In a stark departure from the past, Social Security benefits are no longer tax-free for most beneficiaries, thanks to a legislative change in 1983 originally intended to impact only the highest-income recipients. According to Ted Sarenski, author of the American Institute of CPA’s “Guide to Social Security Planning,” due to lawmakers’ failure to account for inflation, a majority of Social Security beneficiaries today find themselves owing federal income tax on at least a portion of their benefits.

The taxation of Social Security benefits is based on an individual’s annual “combined income,” which includes adjusted gross income, non-taxable interest, and half of the Social Security benefits. The tax percentage varies based on income brackets, with up to 85% of benefits potentially taxable for those with higher combined incomes. However, those who rely solely on Social Security for income aren’t required to pay income taxes on their benefits. Despite this, even a relatively small amount of additional income can render these benefits taxable.

Taxing Times for Social Security Beneficiaries

A Historical Perspective

In 1983, Congress passed legislation to tax a portion of Social Security benefits for high-income recipients. At that time, less than 10% of beneficiaries were impacted. However, due to the failure of lawmakers to update the law to account for inflation, the majority of Social Security beneficiaries now have to pay federal income tax on at least some of their benefits, according to Ted Sarenski, author of American Institute of CPA’s “Guide to Social Security Planning.”

Understanding Social Security Taxes

Social Security taxes are dependent on your annual “combined income”, which includes your adjusted gross income, any nontaxable interest you receive, and half of your Social Security benefits. For couples filing a joint return with a combined income between $32,000 and $44,000, up to 50% of benefits may be taxable. For higher combined incomes, up to 85% of benefits may be taxable. Single filers with combined income between $25,000 and $34,000 may pay tax on up to 50% of benefits, and up to 85% beyond that.

The "Tax Torpedo" Phenomenon

The unique way in which Social Security benefits are taxed can lead to what is known as the “tax torpedo”, a sharp rise in marginal tax rates followed by a decline. William Reichenstein, professor emeritus at Baylor University, explains that many middle-income households can face marginal tax rates that are 50% to 85% higher than their regular tax bracket due to this phenomenon.

Mitigating the Impact

There are ways to reduce the tax impact. One strategy is delaying the start of Social Security benefits as long as possible. This approach could result in a larger Social Security check and significant tax savings for moderate-income households. Additionally, diversifying retirement funds with Roth IRA or Roth 401(k) can help reduce taxes on Social Security benefits as withdrawals from these accounts are tax-free in retirement. Another tactic is to make qualified charitable distributions from your IRA to a charity, which are not taxable and do not count towards your combined income.

Final Thoughts

While these strategies can be effective, Sarenski stresses the importance of seeking advice from a tax professional or a financial planner to avoid potential pitfalls like unnecessary taxes, increased Medicare or Affordable Care Act premiums, and premature depletion of funds. The goal, as Sarenski puts it, is to "smooth out your tax rates".

Crive - News that matters