What you haven’t heard before about the taxation of Social Security benefits

[Lsbcal]

Quote:

Originally Posted by NW-Bound Stop to smell the roses and miss out on mucho tax breaks? Not this scroogy guy! I have to go with the flow.

Well, no roses for you. But if you slow down a bit there are still some carnations left.

[NW-Bound]

Either carnations or roses will have to wait until April 16.

[Independent]

"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.

[Lsbcal]

When I did a simple table and varied the IRA withdrawals by 10k increments, the max marginal Fed + State rate was 33%. I definitely won't be doing that line in the tables.

I did not check the max marginal rate that I could hit by going in smaller increments. I might have got higher by doing this but who cares, one is not going to optimize for hitting the max marginal rate, I hope.

All this depends on ones unique tax situation (Fed and State).

[jclarksnakes]

Geez, this retirement planning stuff is complicated but thankfully every cloud has a silver lining. There is no way we will be able to keep our income low enough for less than 85% of our future SS to be taxed so we do not have to worry about this.

[REWahoo]

Quote:

Originally Posted by jclarksnakes There is no way we will be able to keep our income low enough for less than 85% of our future SS to be taxed so we do not have to worry about this.

+1

I came to that conclusion several years ago.

[audreyh1]

Quote:

Originally Posted by jclarksnakes Geez, this retirement planning stuff is complicated but thankfully every cloud has a silver lining. There is no way we will be able to keep our income low enough for less than 85% of our future SS to be taxed so we do not have to worry about this.

+2

Thank goodness I can scratch this off the list of things to worry about!!!!!

[aja8888]

Has anybody looked for that asteroid lately?

[kaneohe]

Quote:

Originally Posted by Independent "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....................... \.

You might have a few extra 1000s in that formula? but your general conclusion that the 46% has a limited effect that can be saturated out with more income is true .

[audreyh1]

Quote:

Originally Posted by aja8888 Has anybody looked for that asteroid lately?

I keep reading rumors!

[ziggy29]

I know I've remarked on it here before, but this is part of the reason why someone's taxes can go *way* up when they become widowed. My dad passed in 2005. In 2006 my mom's income dropped by about $8K (the value of her SS benefit; she inherited my dad's larger check when he died), but her federal income taxes nearly doubled (from about $4K to $7K). So on net, her after-tax income dropped by about $11K.

Between being moved to the 25% tax bracket instead of 15% when filing jointly, and having 85% of her SS taxed as "single" instead of 50% when MFJ, the U.S. Treasury seemed to delight in the grief of a widow.

So I'll say it again: It's important to remember the tax impact -- not just the income impact -- of the passing of a spouse. You can pay a lot more in taxes even when your income shrinks significantly. Being shifted into single filing status can be more impactful than the loss of a SS or pension check.

[MichaelB]

Quote:

Originally Posted by ziggy29 So I'll say it again: It's important to remember the tax impact -- not just the income impact -- of the passing of a spouse. You can pay a lot more in taxes even when your income shrinks significantly. Being shifted into single filing status can be more impactful than the loss of a SS or pension check.

That's a very good point.

[imoldernu]

Read the thread until I got nervous. Born before the first American began paying into the plan, and receiving SS in 1998, before it got complicated, am eternally grateful for being able to avoid reading the full pdf.

Old is Good!!!

[Lsbcal]

There has been some discussion of high marginal tax rates when adding SS to RMD's. It turns out for us things are not going to be so bad even if the marginal rates push us up to the start of the high marginal rates (maybe 32%).

This is because only a few thousand will be taxed at the higher rates. So having Roth money to halt the taxation at higher rates is critical here. For us, the actual $'s paid to Fed+State are fairly low even though we might just start hitting those higher marginal rates.

So projecting your tax picture out to your 70's might be a wise move. Having some Roth funds to mix with IRA RMD's might be very wise depending on your total asset, income flows, and tax picture.

[Independent]

Quote:

Originally Posted by kaneohe You might have a few extra 1000s in that formula? but your general conclusion that the 46% has a limited effect that can be saturated out with more income is true .

Thanks. The frustrating thing is that I don't see a way to edit the post this morning. It will just sit there, reminding me to be more careful.

[Options]

Quote:

Originally Posted by Lsbcal I'm guilty as charged. Sometimes I have to step back from complexity and smell the roses.

On the Bogleheads Forum site, there was a mildly fierce (if ever there were such a thing) debate regarding the merits of devising a complex variable percentage withdrawal method for PF decumulation. Went on for several pages, even ending up as a spreadsheet on another part of the site. Best part was this sage advice (IMHO) from one of the posters regarding complexity:

"After long thought, and years of reading posts here, and just thinking about the well known fact from psychology that humans are very poorly wired to intuitively understand probability and make rational decisions in the face of uncertainty, I think people, otherwise very smart people, have an extremely hard time really at a gut level dealing with the level of uncertainty in investing and retirement planning that exists despite all our hard work to make it otherwise. Thus we agonize over hyper-precise rebalancing schemes, worry about precisely how to set an asset allocation, despite huge amounts of evidence that no one can estimate future returns with any accuracy we read and many (including our resident experts both those that post regularly and not so regularly) insist that to invest well we much make such predictions. And why we have such fascination with various safe withdrawal rate schemes.

I'm sympathetic. It took me a long time, and much modeling and calculating, not just in things like the above withdrawal rates, but more importantly in studying the sensitivity of results to changes in assumptions to get to where I am today. I would suggest that if anyone likes precise calculations, much can be learned by looking at the changes in results due to sensitivity to errors in assumptions. As a hint, just as compound growth in your portfolio over decades is a great thing, the compound growth in errors over decades is just as powerful.

One could certainly at age 30 calculate to the nearest dollar what they plan to spend at age 60. And people could get together to discuss different methods of how to do this calculation to the nearest dollar. But would it be very useful compared to a back of the envelop estimate? Would it even be useful at all?"

Lately I have been asking myself, do I really want to optimize every last dollar of my PF? If I pay some more to the tax man due to RMD's/SS txs (while enjoying a robust retirement) shouldn't I be spending my time on the things that make retirement/life worthwhile? Counting every last nickel in the PF isn't one of them. Just some thoughts I've been pondering lately...

[NW-Bound]

Quote:

Originally Posted by Options Lately I have been asking myself, do I really want to optimize every last dollar of my PF?...

And you really cannot. Tax law changes and variations in future return mean one's spreadsheet may be all out-of-whack 10 or 15 years from now. We would have to make too many assumptions.

I will still do Roth conversions of course as I do not see any drawback, but I do not attempt to quantify that tax advantage this far from that RMD date.

[Ed_The_Gypsy]

Another gotcha:

If I understand correctly, distributions from a Roth at any time in your life (this I gotta confirm) will include a 10% penalty if taken less than 5 years after the money was put in. The count starts as of January 1 of the year following the contribution. So, Year 1 = contribution/conversion. Years 2-6, have to sit on it. Year 7 = first opportunity to withdraw without penalty.

This is complicating my strategy, but does not break it.

Another reason to START EARLY! Learn from my mistakes.

[kaneohe]

Quote:

Originally Posted by Ed_The_Gypsy Another gotcha: If I understand correctly, distributions from a Roth at any time in your life (this I gotta confirm) will include a 10% penalty if taken less than 5 years after the money was put in. The count starts as of January 1 of the year following the contribution. So, Year 1 = contribution/conversion. Years 2-6, have to sit on it. Year 7 = first opportunity to withdraw without penalty. This is complicating my strategy, but does not break it. Another reason to START EARLY! Learn from my mistakes.

no 5 yr clock on withdrawing contributions....can take out anytime.
5 yr clocks on conversions unless stopped by 5 yr clock on original Roth and age 59.5.
I believe your year counting overcounts the required yrs.

Google on the fairmark.com site "roth withdrawal table kawill" to find a relevant thread and be sure to look at the latest post in the threads since there were some changes along the way.

[Ed_The_Gypsy]

Thanks, kaneohe,

The 5-year clock on conversions is a problem for me. I have to check on the 59.5 issue.

Thanks for the link.