Beware the Social Security ‘Tax Torpedo’

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The combination of different income types in retirement can create some really ugly distortions in tax rates.

If you’re an advisor who has done Social Security planning, I’m sure you’ve heard of the “Tax Torpedo.” One of the earliest references was from Scott Burns, a columnist who wrote a lot about Social Security well before most financial advisors were paying attention.

As a refresher, Social Security income by itself is not taxable. It only becomes taxable when other income causes the total “provisional income” to exceed certain thresholds. It’s a multi-step process that can be calculated using the IRS worksheet. This structure creates what’s known as a “tax torpedo” or a “snowball effect.”

If you aren’t familiar with the tax torpedo, consider this example:

John is single and has $2,000 per month in pensions and $2,000 per month in Social Security. His tax return shows he is in the 12% bracket. John also has a brokerage account where he usually recognizes about $10,000 of long-term capital gains and qualified dividends per year. This year, he takes an extra $2,000 out of his IRA. Being in the 12% bracket, he expects to pay $240 extra in federal income tax. His tax bill on the extra withdrawal is actually $474, almost double what he expected, because each additional dollar of IRA withdrawal dragged in 85 cents of a Social Security dollar that would otherwise have been tax free.

If John takes out another $234 to pay the extra tax, he’ll actually lose 49.95% to federal income tax because that withdrawal will not only create additional taxable Social Security benefits, but will also push some capital gain that would have come through at a 0% rate into a 15% capital gains tax rate. Whether you call it a torpedo, a snowball, or something else, the combination of different income types in retirement can create some really ugly distortions in tax rates.

The standard deduction is mostly overlooked in the financial planning literature. The standard deduction allows a certain amount of income to be received tax free. For a married couple filing jointly in 2018, the amount is $24,000, plus an additional $2,600 if both are over 65 years old or blind. Each year, it increases with inflation. Does that mean they can take an IRA withdrawal of $24,000 before tax kicks in? Not in the presence of Social Security.

The amount they can withdraw before creating taxable income varies based on Social Security. For example, a couple with $10,000 of Social Security income can take the full $24,000 out of an IRA without making any of their Social Security benefit taxable, but a couple with $80,000 of Social Security benefits can only withdraw about $11,500 from an IRA before losing 18.5 cents of each additional dollar to federal income tax.

If you used the IRS worksheet to figure out how much you could withdraw before experiencing any tax impact, you would have to complete it multiple times, increasing the ordinary income amount each time in order to figure out how much you can withdraw in the presence of the Social Security benefit.

Read more on ThinkAdvisor.com

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