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Why Social Security Taxes Are Sky-High, and How You Can Avoid Them

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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%.

Social Security Administration Building, Washington, D.C. Source: Wikimedia Commons.

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.

To learn more about a few low-cost ETFs that have great promise for delivering profits to shareholders in a recovering global economy, check out The Motley Fool's special free report "3 ETFs Set to Soar During the Recovery." Just click here to access it now.


Read/Post Comments (18) | Recommend This Article (12)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 06, 2013, at 2:02 PM, JJanJJones wrote:

    It's time the United States government stopped penalizing people for making wise financial decisions, planning for their retirement and/or working hard. It's time for a flat tax. That's the only fair way to tax. Those with more money will pay more than those who have less money, while paying the same percentage. And ALL income should be taxable - no exceptions and no deductions. That way no one can get around their tax responsibilities, leaving others to shoulder additional tax load. I have a real problem with people who sacrificed and saved their whole life, so they would be able to retire relatively comfortably being punished, and people who always had to have the biggest and newest houses and cars, took great vacations every year, etc., rather than saving, being rewarded on the back of those who were financially prudent.

  • Report this Comment On April 06, 2013, at 2:29 PM, mobadthangood wrote:

    I guess what I'm curious about is WHY SS is taxed again?

    When I was working SS was taken out of my gross income. That means the money was already taxed.

    WHY do I have to pay taxes on it again?

  • Report this Comment On April 06, 2013, at 2:31 PM, CharlieTX wrote:

    And to make matters worse, Obamacare places strict limits on the amount of medical deductions one can claim. Whoever came up with the idea of taxing us on money we spend for doctors appointments and prescriptions should be exiled to Iran or North Korea.

  • Report this Comment On April 06, 2013, at 2:51 PM, TimToad61 wrote:

    They are only taxed again if you earn over $25,000 in income per year in retirement as a single and $32,000 for a couple above and beyond your SS payments.

    I thought retirement was supposed to be a time of rest and enjoyment the fruits of earlier labors? Even if one has large amounts of investment income set aside, if a person isn't smart enough to shield the growth of those investments from the taxman by utilizing Roth IRAs, etc. then they should get taxed on the excess income they produce.

    After all, seniors utilize the most public services of all age groups.

    Besides, if you averaged $50,000 income per year while working, you had about $3,750 withheld annually starting in the 90's. All the earlier decades, your withholdings were far smaller. Your monthly benefit on that kind of average income is about $1,500-$1,700 per MONTH now. Not a bad deal!

  • Report this Comment On April 06, 2013, at 2:57 PM, birder1500 wrote:

    Considering that you already paid taxes on that money when you earned it, it is even worse than that. It is taxed twice--once when it is earned and then again when it is returned to you. The government is so sweet.

  • Report this Comment On April 06, 2013, at 3:15 PM, gvca876 wrote:

    This article is very inaccurate. It should probably be removed. Readers should go to IRS publication 915 and do some calculations.

  • Report this Comment On April 06, 2013, at 5:25 PM, dyoung1961 wrote:

    This is how the US government is stealing from the social security system and why Social Security is running out of money. They give social security out from the Social Security Funds to people that have other income and then tax it back. But the amount they tax back does not go back into the Social security funds, like it should, it goes back to the US general fund. So the government is all for giving out these funds to people that don't need it because it allows them to tax it back to funds they can use for other projects. This is why SS funds are going to run out.

  • Report this Comment On April 06, 2013, at 5:31 PM, DougFC36 wrote:

    Now I am uncertain about this because I always thought that this tax/reduction in SS benefits stopped at your full retirement age. Show me.

  • Report this Comment On April 06, 2013, at 5:47 PM, jackhenery1 wrote:

    I plan to save up all the taxes that I have saved from my Social Security, which by the way I paid into and paid the taxes before, and present it to President Obama. I encourage everyone to do the same.

  • Report this Comment On April 06, 2013, at 6:44 PM, sweetoldal wrote:

    The tax calculation is not accurate. The maximum % of social security benefits which can be taxed is .85 X the benefit. Therefore a person receiving an annual benefit of $16,000 / year and having enough other income to require the maximum taxation of his benefits would pay tax on $13,600. Assuming the top tax rate of 39.6% would result in a tax of $5,386.

    $5386/16000 = 33.6625% and this rate only comes into play if the taxpayer has taxable income in excess of @$400,000 for married taxpayers in 2013.

    A person with taxable income in the $50,000 range would be paying less than 15% on their social security benefits.

  • Report this Comment On April 06, 2013, at 6:48 PM, aegis111 wrote:

    mobadthangood,

    The money isn't double taxed. It's simply withheld until you start receiving benefits, kind of like unemployment benefits.

  • Report this Comment On April 06, 2013, at 7:31 PM, TMFGalagan wrote:

    @DougFC36 - The reduction in benefits for working if you haven't reached full retirement age is a completely different issue. Taxation of SS benefits applies to everyone, regardless of age.

    best,

    dan (TMF Galagan)

  • Report this Comment On April 06, 2013, at 7:32 PM, TMFGalagan wrote:

    @sweetoldal - Your calculation doesn't capture the point. The idea is that if you earn an extra $1, you can have an extra $0.85 of your SS benefits taxed, meaning that you'll pay tax on $1.85. 1.85 x 25% marginal rate = 46.25%.

    best,

    dan (TMF Galagan)

  • Report this Comment On April 06, 2013, at 7:33 PM, motley9999 wrote:

    This article is almost totally nonsense. If you know

    so little about investing and taxes that you

    attempt to heed its advice, you don't deserve

    to have enough money to worry about it. I hope

    this is not "disrespectful" but the article is

    just not helpful.

  • Report this Comment On April 07, 2013, at 12:09 AM, nihonbarb wrote:

    How much of this money is stolen to pay for the democrats pet union pensioners that are so under funded that they are bankrupting every state and the nation.

  • Report this Comment On April 07, 2013, at 12:44 AM, Heezer wrote:

    This story is completely inaccurate. Please remove the post.

  • Report this Comment On April 07, 2013, at 9:18 AM, Grandpastu wrote:

    I'm willing to bet this doesn't affect Congressmen, who, after all, make all these laws that affect the general population and exempts Congress!

  • Report this Comment On April 07, 2013, at 9:26 AM, TMFGalagan wrote:

    @motley9999, @heezer - The article may be difficult for some to understand, given how it talks about marginal tax rates. But sadly, it's not inaccurate at all.

    best,

    dan (TMF Galagan)

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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