When planning for retirement, Social Security benefits are a crucial part of the equation. However, there's a tax surprise that many retirees aren’t aware of - the Social Security tax torpedo. This sneaky tax situation can significantly reduce the amount of Social Security benefits you get to keep.
In today's post, I'll break down what the Social Security tax torpedo is, how it impacts your benefits, and the strategies you can use to sidestep it. Whether you’re married or single, the cost of inaction is very high and understanding and addressing this tax trap can make a huge difference in protecting your retirement income.
Understanding Taxation of Social Security Benefits
Most retirees don’t realize that Social Security benefits can be taxed, and to get a handle on the Social Security tax torpedo, you first need to understand how these benefits are taxed. Unlike other income, Social Security benefits aren’t automatically taxed. Instead, the taxability of your benefits depends on something called “provisional income.”
What Is Provisional Income?
Provisional income is the key to understanding how much of your Social Security benefits will be taxed. It is equal to:
Modified Adjusted Gross Income (MAGI) + Tax-Exempt Interest + ½ of Social Security benefits.
Tax-exempt interest includes interest earned from municipal bonds and other tax-exempt investments.
Depending on your provisional income, up to 85% of your Social Security benefits could be subject to federal income taxes.
Filing Status and Its Impact on Social Security Taxation
Your filing status plays a crucial role in determining when your Social Security benefits become taxable.
Married Filing Jointly: If you and your spouse file a joint return, you have higher provisional income thresholds, allowing for more income before your Social Security benefits are taxed. Generally, if
Your provisional income Is less than $32,000, none of your social security benefits will be taxed.
Your provisional income is between $32,000 and $44,000, up to 50% of your benefits can be taxed, and
Your provisional income is over $44,000, up to 85% of your benefits may be taxed.
Single filers, Heads of Household, Qualified Widowers, and Married Couples Filing Separately but living apart are subject to the following provisional income thresholds.
If your provisional income Is less than $25,000, none of your social security benefits will be taxed.
If your provisional income is between $25,000 and $34,000, up to 50% of your benefits can be taxed
If your provisional income is more than $34,000, up to 85% of your benefits may be taxed.
As you can see, single filers have lower thresholds, which means a larger portion of their Social Security benefits could be taxed, especially if they’re used to filing jointly. Also, people with substantial income in addition to Social Security might find up to 85% of their benefits taxed.
How the Social Security Tax Torpedo Works
When Congress decided to tax Social Security benefits, the goal was to recapture some of the benefits from high-income individuals who didn’t rely on them as much. However, because the income thresholds set in 1994 haven't been adjusted for inflation, an increasing number of Americans are now finding themselves taxed on their Social Security benefits.
If your provisional income crosses these thresholds, the lesser of 50% (or 85%) of your Social Security benefits or the amount by which provisional income exceeds the threshold is added to your gross income for tax purposes.
Example how the Social Security tax works in practice
Let’s say John and Jane are a retired couple filing jointly with an adjusted gross income of $30,000 and they receive $20,000 in Social Security benefits each year. To figure out how much of their Social Security benefits will be includable in their taxable income, we first calculate their provisional income:
$30,000 + $10,000 (half of their Social Security benefits) = $40,000. Since this is below the $44,000 threshold, only 50% of their benefits are taxable.
The next step is to calculate lesser of:
½ of their Social Security benefits which is $10,000, or
½ of the amount by which their provisional income exceeds the income thresholds, which is $4,000 (calculated as $40,000 minus $32,000 times 0.5)
Now, let’s say John and Jane withdraw an extra $5,000 from their retirement account, increasing their provisional income to $45,000. This extra $5,000 pushes them above the $44,000 threshold, making 85% of their Social Security benefits taxable. The outcome? $6,850 of their Social Security benefits now count as taxable income, leading to a much larger tax bill than they expected.
To calculate the exact amount of Social Security benefits that will be included in taxable income, we need to find the lesser of:
85% of your Social Security benefits which is $17,000, or
85% of the amount by which provisional income exceeds the income thresholds: $45,000 minus $44,000 = $850
Plus the lesser of:
$6,000 for married filing jointly (50% of the difference between $32,000 and $44,000), or
½ of the amount by which provisional income exceeds the Social Security 1st Hurdle Amount ($45,000 - $32,000) = $13,000 x 0.5 = $6,500
Thus, $6,850 of Social Security benefits is subject to federal income tax. This is a prime example of the Social Security tax torpedo in action.
What Is the Social Security Tax Torpedo?
The Social Security tax torpedo describes the sharp increase in taxes on Social Security benefits as your income rises. When your provisional income crosses certain thresholds, each additional dollar of income can trigger taxes not just on that income, but also on up to 85% of a corresponding dollar of Social Security benefits. This creates a "torpedo" effect where small income increases lead to disproportionately large tax increases - a real burden for retirees on a fixed income.
It’s important to understand that once 85% of your Social Security benefits become taxable, any additional income won’t trigger more of your Social Security to be taxed.
To illustrate this, let's take a closer look at John and Jane and how the Social Security Tax Torpedo impacts them.
In this example, John and Jane each receive $25,000 in Social Security benefits, totaling $50,000, with no other income. At this level, none of their Social Security benefits are taxable. However, as they start earning additional income, things begin to change. Once their Modified Adjusted Gross Income (MAGI) plus tax-exempt interest reaches $23,000, their marginal tax rate jumps to 18.5%.
This is because they enter the 10% federal tax bracket, and 85% of their Social Security benefits become taxable. In practical terms, an additional $1,000 in MAGI increases their taxable income by $1,850, raising their tax bill from $100 to $185.
As their MAGI continues to rise, their federal marginal tax rate increases to 22.2% at $35,000 and remains at that level until their taxable income exceeds $62,000. This 22.2% effective marginal tax rate is a combination of the 12% federal tax bracket and the tax on 85% of their Social Security benefits. Under normal circumstances, an extra $1,000 in gross income in the 12% tax bracket would result in $120 in additional taxes. But since 85% of John and Jane's Social Security benefits are taxable, that same $1,000 increase in MAGI results in $1,850 being added to their gross income, pushing their tax from $120 to $222, which corresponds to a marginal tax rate of 22.2%.
The MAGI of $62,000 marks the upper limit of the “tax torpedo,” where $50,000 of their Social Security benefits are taxed at 85%. Beyond this point, any further increase in MAGI won’t result in additional taxes on Social Security benefits, and only the applicable marginal tax rate will apply to the extra income. Therefore, it’s crucial to stay below that threshold to avoid higher taxes.
Strategies to Avoid the Social Security Tax Torpedo
Now that you know what the tax torpedo is, let’s talk about how to avoid it.
While wealthier individuals might not be able to dodge taxes on 85% of their Social Security benefits, those with more modest resources can take steps to reduce or even completely avoid this tax torpedo.
Delay Social Security Benefits
In addition to managing your tax brackets and keeping your income within the lowest possible tax bracket, delaying Social Security benefits until full retirement age or later can be a smart strategy to minimize or avoid the Social Security tax torpedo. Not only does delaying often result in higher benefits and total income if you live past the breakeven point, but it also reduces the number of years your benefits are taxed, as the torpedo tax only affects those receiving Social Security benefits.
If you’re still working in your 60s and earning enough income to trigger the tax, delaying benefits might be especially beneficial. If you're planning for early retirement, consider using your tax-deferred accounts, pensions, or annuities to manage your expenses while postponing your Social Security benefits for as long as you can. This approach often leads to better financial results when taxes are taken into account compared to claiming benefits earlier.
Keep Your Expenses Low
Before you start receiving Social Security benefits, try to make gradual lifestyle adjustments and reduce your expenses. Paying off debt, like a mortgage, can lower your retirement spending needs by thousands each year. If you’re already receiving benefits, managing your expenses can help you avoid the Social Security tax torpedo. Focus on essential needs like housing, food, and healthcare. This allows you to reduce discretionary spending and potentially lower the amount you need to withdraw each year.
If you’re planning a major purchase, time it strategically. Rather than withdrawing a large amount in one year, spread the expense over several years or use alternative funding sources, such as a home equity line of credit, that don’t increase your AGI. This approach is especially beneficial when selling significant assets or receiving a lump sum.
If you’re in one of the 10 states taxing Social Security benefits, consider relocating to a state that doesn’t.
States That Tax Social Security Benefits in 2024
Colorado
Connecticut
Kansas
Minnesota
Montana
Nebraska
New Mexico
Rhode Island
Utah
Vermont
Also, use your health savings account (HSA) funds for qualified medical expenses in retirement - HSA withdrawals are tax-free and won't affect your provisional income.
While I understand that downsizing, relocating, or cutting down your expenses is easier said than done, smart spending can help you avoid drawing on taxable income, keeping your provisional income below those tax torpedo thresholds.
Tax-Efficient Withdrawals
To avoid taxable income, keep your retirement accounts intact and let them grow tax-deferred for as long as possible. When you do need to start withdrawing, be strategic – delay withdrawals from your traditional IRA or 401(k) and instead draw from Roth accounts, which don’t count toward provisional income.
When dealing with Required Minimum Distributions (RMDs), the size of your retirement account can significantly impact your taxes. If you anticipate that your RMD will push you into a higher tax bracket, try taking smaller withdrawals before turning 73 to spread out the tax burden. This strategy can help lessen the effect of large RMDs on your provisional income.
In addition to that, consider spreading out income from other sources, such as pensions or annuities – this can help you stay below the income thresholds. For example, if you have a permanent life insurance policy, consider taking withdrawals or loans against the cash value. These funds are generally not considered taxable income, and therefore, don’t affect your provisional income.
Roth Conversions
Converting a portion of your traditional IRA or 401(k) to a Roth IRA before you start taking Social Security benefits can give you more time to perform Roth conversions and reduce the years in which your benefits are taxed. While you’ll pay taxes on the conversion, Roth distributions aren’t included in provisional income, so you can take withdrawals without triggering the Social Security tax torpedo.
This strategy is most effective when you convert during years of lower income, like early retirement before RMDs start. It can also help later by reducing RMDs and easing the need for taxable withdrawals to cover retirement expenses.
Qualified Charitable Distribution (QCD)
If you are charitably inclined and don’t rely on retirement account distributions, a QCD allows you to donate up to $105,000 (in 2024) annually directly from your Traditional IRA to a qualified charity. The donated amount doesn’t count as part of your AGI or provisional income, helping to reduce the amount of Social Security benefits that are taxable.
This strategy is particularly beneficial for those who are over 70½ years old and subject to required minimum distributions (RMDs).
Minimize Taxable Interest and Dividends
If you’re still saving and investing outside of retirement accounts, consider using tax-efficient funds or investment vehicles that generate minimal taxable interest or dividends. Aligned with your risk tolerance, consider buying and holding growth-oriented investments that focus on capital appreciation rather than income.
If you invest in municipal bonds to earn interest that is typically exempt from federal income tax, and sometimes from state and local taxes as well, be aware that this interest is still included in provisional income. Nevertheless, municipal bonds can be a tax-efficient way to earn income without significantly boosting your provisional income, helping you avoid the Social Security tax torpedo.
Tax-Loss Harvesting
If you have capital losses, consider tax-loss harvesting which involves selling investments at a loss to offset gains and lower your AGI. Reducing your AGI can decrease your provisional income and potentially help you avoid the Social Security tax torpedo. Just be careful, as the IRS has specific rules for valid tax-loss harvesting transactions.
Buy Annuities
Some annuities, like non-qualified immediate annuities purchased with after-tax funds, let you receive a portion of the payout that’s non-taxable, reducing the amount of income that counts toward your provisional income.
Deferred annuities can also help lower your provisional income. For example, you can transfer $200,000 (2024) from an IRA or 401(k) into a Qualified Longevity Annuity Contract and defer income until age 85. This would allow you to delay required minimum distributions on that portion of your retirement savings, which can reduce your provisional income and potentially cut or even eliminate taxes on your Social Security benefits.
The Cost of Inaction
The Social Security tax torpedo is a hidden trap that can significantly impact your retirement if you’re not prepared. Understanding and planning for it isn’t not just about optimizing your taxes - it’s about protecting your retirement income. Ignoring this issue could have significant consequences:
Unexpected Tax Bills
If you’re not prepared, you could find yourself paying taxes on up to 85% of your Social Security benefits. This can result in unexpected tax bills that take a bigger bite out of your retirement income than anticipated.
Compounding Financial Challenges
The financial hit from the Social Security tax torpedo can compound over time. As your taxable income increases, you may find yourself in a higher tax bracket, paying even more in taxes, and possibly losing out on other income-dependent benefits and credits.
Reduced Retirement Income
Higher taxes on your Social Security benefits mean less money in your pocket each month. This reduction in income can force you to draw down more from your savings or investments, potentially depleting your resources faster than planned.
Erosion of Wealth
By not managing your provisional income, you risk eroding your wealth over time. This erosion can impact your ability to leave a legacy for your loved ones or support causes you care about.
Final Thoughts
Planning for retirement requires more than just saving money - you need to understand how taxes will impact your income. The Social Security tax torpedo is a prime example of how a little-known tax rule can lead to higher taxes on your Social Security benefits. By knowing how provisional income works, understanding the thresholds, and implementing strategies like delaying benefits, managing expenses, and making tax-efficient withdrawals, you can reduce the impact of this tax torpedo and protect your retirement income.
Looking to Maximize Your Social Security Benefits?
If you need help reviewing your Social Security statement and deciding on the best time to claim your benefits to maximize your resources, please feel free to book a meeting with us. You can also check out a sample report here.
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