There are still a few months before tax season begins, but for retirees on a fixed income, any hint of a higher tax bill requires careful pre-planning. For the most part, typical American retirees generally have modest incomes and are therefore in relatively low tax brackets. But one thing that many people don’t realize is that even after they’ve retired, a surprising tax rule could effectively cause them to pay much higher taxes, with marginal rates exceeding 40% in some circumstances.
The reason has to do with the way that Social Security benefits get taxed. Many people are shocked when they learn that the IRS sometimes claims a cut of their monthly retirement checks from Social Security, but the worst part about the current law behind Social Security taxation is that for certain groups who’re affected by the provisions, effective marginal tax rates shoot even higher than what the richest American taxpayers currently pay.
Taxes and Social Security
Not everyone has to pay tax on their Social Security, but if you make more than a certain amount of income, then a portion of your benefits can become taxable. In order to determine whether you’ll owe any tax on your Social Security income, you need to take your total income from sources other than Social Security and add in one-half of the benefits you’ve received from Social Security over the course of the year. You’ll then use that total amount to see whether your countable income is above the threshold amounts below.
As you can see above, if your income exceeds the amount in the middle column above, then up to half of your Social Security benefits get added to your taxable income for IRS purposes. Rise above the figure in the rightmost column above, and that one-half figure for including benefits in taxable income rises to a maximum of 85%.
How tax on Social Security can produce huge marginal tax rates
The problem comes in when you consider the real-life application of this rule. For instance, say that a single person gets $1,500 per month in Social Security and takes monthly withdrawals of another $3,000 from a traditional IRA or 401(k) account. In that case, countable income would be $36,000 plus half of $18,000, or $45,000 total. That’s well above the $34,000 upper threshold for taxing Social Security. In this case, the result would be that $13,850 of the $18,000 in benefits would be subject to tax.
Now consider a similar situation except that the person takes an extra $1,000 IRA withdrawal one time to pay for unexpected expenses. That boosts countable income to $46,000, and $14,700 of benefits would be included in taxable income. In other words, not only did the withdrawal produce $1,000 in extra taxable income due to the IRA rules, but it also added another $850 in taxable income because more Social Security benefits were included.
Taxing $1.85 for every $1 in additional IRA withdrawals effectively raises marginal rates by 85%. Therefore, if you’re in the 22% tax bracket in retirement, then that increase would boost your effective marginal tax rate to 40.7%. Even for those in lower tax brackets, the hit can have a dramatic impact on your after-tax income.
Manage your tax liability
The key here is that retirees have at least some control over the money they take out of their tax-favored retirement accounts. By being aware of the limitations on income that retirees face in determining whether Social Security benefits will be taxable, you can hopefully be smarter about taking withdrawals from IRAs and find ways to keep yourself below the thresholds at which more and more of your benefits will get taken away by the IRS.