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.
