Retiree Portfolio It's Income Tax Time

By David Braze (TMF Pixy)

ALEXANDRIA, VA (JAN. 18, 2000) -- Income tax season is upon us, so I thought in this week's column I would look at the issue of how Social Security may affect the total taxes retirees might be required to pay. In Step 9 of the 13 Steps to Foolish Retirement Planning, I address that issue by saying:

"When and how does Social Security get taxed, you ask? The computation, like all Infernal [sic] Revenue Service requirements, is a tad complicated. In fact, they have a special worksheet just for that purpose. The math starts with your Adjusted Gross Income. To that you add one-half of all Social Security benefits and all unearned income received during the year. The latter almost always comes from tax-exempt interest received from municipal bonds (a favorite retiree investment). If the computed total is larger than $25,000 (single) or $32,000 (married filing jointly), then up to 50% of the Social Security benefit will be taxed. If the amount is larger than $34,000 (single) or $44,000 (married filing jointly), then up to 85% of the Social Security benefit will be taxed. To determine the exact amount that will be taxed, you must complete the handy-dandy worksheet supplied by the IRS for that purpose. Doesn't that sound like fun?"

Fun or not, it is still a drill all retirees who draw Social Security must face. Therefore, it merits some consideration to see how that fits in with our income tax planning for the year. Let's look at an example retired couple, John and Mary, who have the following joint income for 1999:

Pensions & Taxable Investments        $29,500
Municipal Bond Interest                 2,000
Social Security Benefits               14,000
In this scenario, their preliminary Adjusted Gross Income (AGI) consists of their pension and their taxable investment income, or $29,500. To that number, they must now add all of their tax-free municipal bond interest ($2,000) and one-half of their Social Security benefits ($7,000). The resulting sum determines if any of the Social Security benefits will be taxed, and it will give them their Modified Adjusted Gross Income for the Social Security taxation test. If the sum exceeds either the $32,000 or the $44,000 threshold, then part of the Social Security will be taxed. Here's how it works:
Preliminary Adjusted Gross Income      $29,500
Tax-free municipal bond interest         2,000
50% of Social Security benefits          7,000
   Modified Adjusted Gross Income      $38,500
Less first threshold amount             32,000
   Excess over first threshold          $6,500
John and Mary have exceeded the first test threshold (but not the second), so now they must determine what part of their Social Security benefit will get taxed as ordinary income. That amount is the smaller of one-half of the excess determined above or one-half of the Social Security benefit received during the year. One-half of the excess is $3,250 ($6,500 divided by 2). One-half of the benefit is $7,000 ($14,000 divided by 2). $3,250 is smaller than $7,000, so $3,250 gets entered on the appropriate line of their income tax return as that part of Social Security that must be declared as taxable income for the year. And that, in turn, brings their AGI to a total of $32,750 ($29,500 plus $3,250).

Didn't I tell you this was fun? But wait! There's more. Let's change things slightly by making John and Mary age 70 1/2 when mandatory minimum required withdrawals must begin from any traditional IRAs they have. To date, they haven't touched these accounts, but now they must. In fact, they had to take $10,000 this year, all of it taxable and all of it part of John and Mary's preliminary AGI. How does that alter the situation? Now their modified AGI and their excess over the two thresholds becomes:
Preliminary Adjusted Gross Income      $39,500
Tax-free municipal bond interest         2,000
50% of Social Security benefits          7,000
   Modified Adjusted Gross Income      $48,500

Excess over the first threshold ($48,500 - $32,000)    $16,500
Excess over the second threshold ($48,500 - $44,000)   $ 4,500

In this instance, John and Mary must determine the smaller of:

a. 50% of the excess over the $32,000 threshold            
   plus 35% of the excess over the $44,000 threshold
   [($16,500 x 0.5) + ($4,500 x 0.35)]                    $ 9,825

b. 85% of the Social Security benefit ($14,000 x 0.85)    $11,900

c. 50% of the Social Security benefit plus 85%
   of the excess over the $44,000 threshold 
   [($14,000 x 0.5) + ($4,500 x 0.85)]                    $10,825
The smallest of those three computations, or $9,825, now gets added to John and Mary's preliminary AGI of $39,500 to bring their AGI to $49,325.

In the first case, John and Mary ended up with $3,250 in additional taxable income, and in the second example with $9,825 more. Did they plan for the tax on that income? If not, they could be in for a rude surprise. Not only will they pay more in income taxes, they may also be slapped with a penalty for a failure to pay enough estimated withholding taxes during the year. Estimated income taxes are not withheld from Social Security payments unless the recipient has submitted Form W-4V (Voluntary Withholding Request) to the Social Security Administration (SSA) for that purpose. In the absence of that action, we are responsible for those payments, and unless we meet one of the limited safe harbor tests for not making those payments quarterly, then failure to do so will result in a penalty on top of the taxes due at tax-filing time.

Thus, a word to the wise: Don't forget the potential of Social Security taxation. When you do your taxes this year, run a pro forma tax return for next year's income tax return. If you see that your Social Security may be taxed, then either submit Form W-4V to the SSA or make your necessary quarterly estimated withholding payments unless you're absolutely sure you won't owe a penalty for not doing so.

That's it for today. See you next week. In the interim, post your comments and queries on our Retired Fools board.

Best to all... Pixy