"If you're not careful, the rules for Social Security taxation could create a tax rate of 46% on your IRA withdrawals!"
I think we've all heard this. I understand the theory. If I'm in a 25% marginal tax bracket, and if the taxable portion of my SS benefit is lower than 85%, then an additional $1,000 of regular income could cause me to pay $1,000 x .25 x ($1,000 + .85 x $1,000) = $462.50 in additional taxes.
For some reason, I remember looking at that and thinking "Won't happen to me". This thread prodded me to go look again, after all, the example in the OP sure looks serious. Maybe it would make sense to do some Roth conversions at 25% just to avoid the 46%.
When I do the math, it seems that very few people should actually fall into this situation. In order to get into this, I'd need an income that is:
a) high enough to get into the 25% marginal bracket, but
b) low enough that less than 85% of my SS benefit is taxable.
I'm married, so a did some numbers for a joint return.
For example, if our combined SS benefit is $50,000, and we have $54,000 of ordinary income, the taxable portion of our SS will be $35,750 (Test 3 in the OP), and our AGI will be $85,750. That's not enough to get into a 25% tax bracket.
OTOH, for the same $50,000 SS benefit, if we have $62,000 of ordinary income, 85% of our SS benefit will already be taxable, so the marginal impact of additional income is just the regular 25% rate.
The difference between $52,000 and $64,000 is pretty small. Very few people have $50,000 SS benefits, and even fewer have ordinary incomes between $52k and $64k. And, even for people in that window, the 46% would only apply to the first few thousand of additional income, before they cross the $64k border.
If I do some more math, I think that no couple with a SS benefit below $42,000 can get into this 46% situation. $42,000 is a substantial SS benefit.
The window widens as SS benefits go up. The OP uses $70,000. But that requires two, maximum earners, both waiting to 70 to start benefits. Even there, the window looks like it's just $51,000 to $72,000 of ordinary income. Many people will be above the $72k or below the $51k.
But, what about the future? The factors in the SS taxable formula aren't indexed for inflation, what will that do? I haven't done any numbers, but intuitively that means that more people will fall into the 85% taxable category, the upper border of this range will come down, and the window will get even narrower.
If this is all true, the 46% is too rare to plan for today, and will get even rarer in the future.
Caveat 1: Of course there are many other factors to consider on Roth conversions or when to start SS. I'm just looking at one, apparently rare, consideration.
Caveat 2: I've been known to make math errors. People who might be concerned about this should run their own numbers rather than just trust mine.
