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Retirees have become increasingly dependent on Social Security for the bulk of their retirement income. Yet even though most retirees have few other sources of income and rely on their retirement savings to supplement Social Security, current tax laws are designed to punish even Social Security recipients with modest incomes, with effective marginal tax rates of as much as 46%, topping what the highest-income taxpayers in the nation pay.
The strange taxation of Social Security
You won't find a 46% rate explicitly written down anywhere in the tax code. But as a recent post from financial planner Michael Kitces explains, buried in the law are provisions that phase in taxes on Social Security benefits for those earning certain amounts of other income.
Here's how it works. The IRS looks at your total taxable income and then adds in half of your Social Security benefits. For every $1 by which that figure exceeds $25,000 for single filers or $32,000 for joint filers, another $0.50 of your benefits get added to your taxable income. Once the figure exceeds $34,000 for singles or $44,000 for joint filers, the amount added to your income jumps to $0.85 per $1.
The net impact of those provisions can dramatically increase the tax rates that Social Security recipients pay. In some cases, those in the 15% tax bracket pay an effective marginal rate of almost 28%, while those in the 25% bracket pay more than 46%.
Are Social Security taxes fair?
Proponents of the tax argue that if you have enough other income, it's only fair to add a tax on Social Security. But the big problem is that in determining the tax, taxable withdrawals from retirement accounts like traditional IRAs and 401(k)s are included in income. Essentially, those who've saved all their lives for their retirement get penalized for their smart financial planning.
Fortunately, there are steps you can take to minimize the impact:
- Use Roth IRAs. Roth IRAs are different from regular retirement accounts in that their distributions are tax-free. They also aren't included in the income figure the IRS comes up with for deciding whether Social Security benefits are taxable, so using Roth assets can cut your tax bill even further.
- Invest in tax-smart funds and ETFs. Investors who use actively managed mutual funds often get hit with big distributions of income and capital gains that are taxable and thereby make them more susceptible to paying tax on their Social Security. But low-cost stock index funds Vanguard Total Stock (NYSEMKT: VTI ) , iShares Russell 2000 (NYSEMKT: IWM ) , and SPDR S&P 500 (NYSEMKT: SPY ) usually pay out only their annual income, generally avoiding capital gains and keeping your other-income figure lower.
- Time your IRA withdrawals. Keeping taxable income below the limit is smart if you can afford it, but many people need their IRA withdrawals to pay living expenses. For them, it may actually make sense to take more money out of IRAs, because once the maximum amount of your Social Security is taxed, your marginal rate goes back down.
Admittedly, calculating the tax on your Social Security is more complex than many retirees can handle. The key, though, is to know that those sky-high tax rates are out there so that you can get the help you need to keep your taxes from soaring.
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