A sneaky Social Security tax is forcing an untold number of retirees to pay a 50 percent effective tax rate on some income. It's not too difficult, however, to reduce the tax by applying minimal effort and a sharp pencil.
"It's a quirky tax issue for retirees because you don't know if it hits you unless you do some calculating," says Joel Isaacson, director of financial planning at Weber Lipshie & Co., a New York City accounting firm. "Most people don't plan ahead to avoid the tax, and by the time they prepare their tax returns, it's too late to do anything about it -- assuming they even realize they're paying these high tax rates. But many retirees can save a few hundred dollars a year by going through the calculation."
The tax trap had its origins in the labyrinth of tax reforms enacted in 1983 that allowed Uncle Sam to tax a portion of a person's Social Security benefits. The Social Security tax can push some retirees into an effective tax bracket as high as 50 percent. The tax easily can be reduced, though, through planning and taxwise investing.
Uncle Sam requires Social Security recipients to determine whether their benefits are taxed by making a separate calculation to arrive at "modified adjusted gross income." Modified AGI is the total of adjusted gross income, interest on tax-exempt municipal bonds plus half of Social Security benefits. For a single person, if the total is more than $25,000 ($32,000 for joint filers), then the lesser of half the Social Security benefits or half the total exceeding $25,000 is taxed. That taxable portion of Social Security benefits must be added to adjusted gross
income when calculating your final tax bill.
Consider the plight of Bill, a 65-year-old retiree. Bill receives a pension of $20,000 a year, plus $5,000 in interest from CDs. In addition, he'll receive $8,000 in Social Security benefits this year. So he must pay tax on $2,000 of his Social Security income. (That's half the amount exceeding the $25,000 threshold.) His adjusted gross income is $27,000.
After he subtracts the $4,250 standard deduction ($3,400 plus $850 for those 65 or older) and the $2,150 personal exemption from his adjusted gross income of $27,000, Bill's taxable income comes to $20,600, saddling him with a federal tax bill of $3,130.
The trouble starts if Bill receives another $1,000 of taxable income. Receiving 3.3 percent more income will raise his tax bill 13.4 percent.
With $1,000 of additional income, Bill's investment income will rise from $5,000 to $6,000. Plus his modified AGI used for calculating his taxable Social Security benefits rises to $30,000. So $2,500 of his benefits -- instead of $2,000 -- will be taxed.
As a result, Isaacson says, Bill's adjusted gross income rises to $28,500 ($20,000 pension income, plus $6,000 of investment income and $2,500 of taxable Social Security benefits). That lifts his tax bill to $3,550. So $420 of that $1,000 in extra income goes to Uncle Sam -- a prohibitive 42 percent marginal rate.
And it would be even worse taxwise if Bill earns that extra $1,000 of income by taking a part-time job. His effective tax rate on that income would rise to 49.65 percent after the 7.65 percent FICA tax is added. "Retirees often wind up paying taxes at much higher marginal rates than they would like to believe," says Isaacson. But there are solutions.
Isaacson suggests retirees analyze their annual income requirements and tax picture to determine if alternatives to taxable investments will cut their tax bills. Income not needed to meet living expenses can be put into a municipal bond or a tax-deferred vehicle to lower a retiree's effective tax bracket. By investing the extra income in a tax-deferred annuity or U.S. savings bond, the retiree will escape taxation on that extra income.
For someone who needs the income to meet living expenses, a municipal bond is a good choice. However, because muni bond income gets figured into the calculation of taxable Social Security benefits, that "tax-free" bond interest actually does get taxed -- at an effective rate as high as 14 percent. Still, that's better than the prohibitive 42 percent rate paid by many retirees on taxable investments.