TRICKS OF THE TRADE
“PHANTOM TAXATION OF SOCIAL SECURITY; DEBUNKING RETIREMENT SAVING MYTHS”
Prepared by Michael Menninger, CFP®
Before launching into any presentation or discussion on the topic regarding the taxation of Social Security, I always preface with the question, “Is Social Security income taxable?” Of course, I get the full range of answers being “yes”, “no”, and “I don’t know”. Strangely enough, the closest answer is the last one, but more correctly, the answer is “it depends”. The taxation of Social Security depends on your other income.
Here’s a little history regarding Social Security. It was enacted in 1935, and the full retirement age was 65 (however, the full retirement age is now 67). Ironically, the life expectancy in 1935 was 65, so I can’t help but joke that the government was ready to pay you, but not until after you have died! Benefits were to be based on payroll tax contributions that the worker made during his/her working life.
Taxes were first collected in 1937 at a rate of 1% of the earner’s wages, and that tax has increased over time. In the early 1970’s, it became apparent that Social Security faced a funding shortfall, so the payroll tax was increased to the current 7.65%. Many other changes were made that would restore the long-term balance of the program for the next 50 years.
Under legislation enacted in 1983, the Federal government began to tax Social Security benefits to raise income for the Social Security Trust Funds. The Funds receive taxes on up to 50 percent of benefits from single taxpayers with incomes over $25,000 and from taxpayers filing jointly with incomes over $32,000. Legislation enacted in 1993 increased the limitation on the amount of benefits subject to taxation from 50 percent to 85 percent for single taxpayers with incomes over $34,000 and for taxpayers filing jointly with incomes over $44,000.
So what does all this mean? In my years as a CERTIFIED FINANCIAL PLANNER™ practitioner, I have seen that these rules are very confusing to most people, and even to many accountants who prepare taxes. After analyzing and scrutinizing these rules of taxation, I have demonstrated (and taught) that this results in the phantom taxation of Social Security. In fact, I have also concluded that an overwhelmingly large percentage of individuals find themselves in an unexpectedly higher marginal tax bracket in retirement. How could that be?
Most people assume that their tax bracket will be lower in retirement because they earn less income. On the surface, that seems logical, but that is certainly not always the case if you look at MARGINAL tax rates. The marginal tax rate represents the tax rate in which you pay if you earn an extra dollar.
Let’s look closer at how the IRS taxes your Social Security. The taxation of Social Security is predicated on the amount of ALL other income, such as pensions, IRA withdrawals, investment income, etc. Without getting too deep into the math, it only takes about $20,000 of other income (for married couples, otherwise it’s about $10,000 for single filers) to cause Social Security to become taxable. At first, every extra dollar you earn causes 50 cents of Social Security to become taxable, but it quickly becomes 85 cents.
So, if one withdraws an extra $1,000 of their taxable retirement savings and that causes $850 of Social Security to become taxable, then they effectively have $1,850 of taxable income on that $1,000 withdrawal. If that individual is in the 15% Federal tax bracket, then they pay $277.50 ($1,850 x 15%) of tax. Well, that represents a 27.75% tax on that $1,000. If that individual was in the 25% tax bracket, then that tax would be $462.50, or 46.25% tax!
We are currently in the lowest income tax structure during our lifetime, and likely ever will be. A married household earning almost $200,000 of income is in a marginal Federal tax bracket of only 22%, so why on earth would they be maximizing their tax-deductible retirement savings when they may be paying a higher tax on that same money in retirement? Needless to say, this does not apply to everyone, but it certainly applies to many middle income earners who have saved a substantial amount in their tax-deductible retirement savings (Traditional 401K or IRA), and expect to be withdrawing more than $20,000 per year in retirement.
This is the trap that many of us have fallen into. We have been taught all these years to make tax-deductible contributions to our retirement plans, so we are effectively funding the time bomb that may explode in retirement. This reversal has been magnified by the tax cuts that were enacted in 2001, and were subsequently reduced in 2018. Particularly given the enormous budget deficits and growing national debt, these historically low tax rates are unsustainable, so that only amplifies the tax problems many will face in retirement.
If you wish to discuss this further to see if / how this may impact you, and how you may be able to mitigate these issues, please contact our office at (610) 422-3773.