Interesting tax situation

[pb4uski]

I have a middle income high school friend whose income taxes I have done for many years.

When I did his 2022 return he owed about ~$1,500 where he normally gets a ~$500 refund. So why?

Well, he started SS in late 2021.. only had a month of SS income in 2021 so the impact was negligible. However, in 2022 he had not only a full years worth of SS but he also worked a full year, retiring in December. He had planned to retire earlier in 2022 but kept deferring it.

There was no SS penalty because he is past his FRA, but he did get whacked on taxes because his earnings caused his SS to be 85% taxable... so his marginal tax rate was 41% (22% * 1.85).

However, we were able to have him do a $7,000 tIRA contribution and he'll get a ~$2,100 tax benefit, changing his ~$1,500 due to a ~$600 refund.

Since he stopped working at the end of 2022 his only income in 2023 will be SS and a rental he has that is nil after depreciation... so he can withdraw the entire $7k and interest plus withdraw some more from his 401k without paying any taxes at all.

Funny thing. He is a bit of a neanderthal and unwilling to do anything on the internet so he went to his friendly local savings bank to do the tIRA. I had told him to do the shortest thing available since he would be withdrawing it shortly. The shortest thing available was a 6-month CD that pays 1%. I told him that 6-month brokered CDs and US Treasury Notes are paying 5.1-5.2% so if I was making 4.1-4.2% on a customer I would be very friendly too.

To boot, he has savings there at 0.1%! I have a feeling that there is a boatload of benign neglect money in demand deposits in the banking system.

While I didn't have him do it, I think I could have had him make the contribution today as a 2022 contribution and then withdraw it tomorrow as a 2023 withdrawal and return it to his savings account and he still would have qualified for the tax benefit which I think would be pretty cool... a $2,100 tax benefit for less than an hour's worth "work".

 

[Dtail]

My parents, now mom only had 350k in regular savings/checking accounts when I took their investments over in June 2017.

 

[MarieIG]

Want to do my taxes? (Just kidding.)

I had a co-worker/ friend who used to discuss finances, ask advice, and never, ever followed it. She spent a fortune on her grown kids and co-signed a student loan for her DGD. She ran through the money from the sale of her home, and two workers' compensation settlements. She took SS about age 67, and didn't withhold taxes. She came into my office crying hysterically when she found out what she owed, because she had no savings whatsoever. (A payment plan was eventually worked out.)

 

[cathy63]

...
While I didn't have him do it, I think I could have had him make the contribution today as a 2022 contribution and then withdraw it tomorrow as a 2023 withdrawal and return it to his savings account and he still would have qualified for the tax benefit which I think would be pretty cool... a $2,100 tax benefit for less than an hour's worth "work".

Yes, this is a nice out for someone who has earned income. I just advised someone to do the same thing last week for a different reason. She had retired in Feb 2022 and got insurance through ACA until she went on Medicare in Jan. Due to vacation payout and underestimating her SS, she ended up with much more income than she expected and was just barely over 400% of the FPL, so the first pass at her tax return had her paying back ~$2900 of advanced premium tax credit.

By putting $500 in an IRA for 2022, her income dropped below 400% FPL so her repayment was capped at $1400. I told her she can take the $500 out as a 2023 withdrawal any day. Basically we shifted $500 of income from 2022 to 2023 and saved her $1500 in Fed taxes.

 

[Irishgirlyc58]

I think I can do the same but with a 457b account.
I received my last paycheck and vacation buyout in January 2022. Doesn’t that qualify me?

If it doesn’t then I also worked for a few months for a nonprofit.
Does anyone know if I can contribute to my 457b account based on that?
Obviously I can google but it seems to get me a lot of information that I don’t need. [emoji23]

 

[timbervest]

There was no SS penalty because he is past his FRA, but he did get whacked on taxes because his earnings caused his SS to be 85% taxable... so his marginal tax rate was 41% (22% * 1.85)

I may be missing something but can you explain this? I can't see anyway anyone would have a marginal tax rate of 41%.

If anything the 85% of his SS might kick him into the 24% bracket but not 41%.

 

[Dtail]

I may be missing something but can you explain this? I can't see anyway anyone would have a marginal tax rate of 41%.

If anything the 85% of his SS might kick him into the 24% bracket but not 41%.

The marginal rate is the rate that the next dollar gets taxed on. So increases in earned income can bring more of the Social Security to be taxed. Thus a marginal rate can easily be higher than the standard tax rates.

 

[timbervest]

The marginal rate is the rate that the next dollar gets taxed on. So increases in earned income can bring more of the Social Security to be taxed. Thus a marginal rate can easily be higher than the standard tax rates.

Hmm, not really sure that's the way it works.

 

[Out-to-Lunch]

Hmm, not really sure that's the way it works.

Well, it is the way it works. You may educate yourself here:

https://www.bogleheads.org/wiki/Taxation_of_Social_Security_benefits

 

[Souschef]

Hmm, not really sure that's the way it works.

The equation is incomplete. It should be (.22*.85*$social security) assuming they would still be in the 22% bracket.
So they would pay 18.7% tax on every dollar of SS, up to the 24% bracket.

 

[Al18]

Timbervest,
Dtail was correct - it’s called the tax torpedo. The tax torpedo is a narrow range of income where a small increase in income will incur a large increase in taxes. If an additional couple thousand in income is realized, the tax rate is lowered. It’s described in detail on the Boglehead wiki https://www.bogleheads.org/wiki/Social_Security_tax_impact_calculator

 

[Big Gun]

The mechanics are that an extra $100 of ordinary income simultaneously pushes hitherto untaxed SS $100 into taxable. The net effect is that $100 plus $85 (only 85% of SS $100 is taxable) = $185 increase in taxable income. At 22% that comes to $40.70. So, $100 of added income increased the tax bill by $40.70. Close enough to be 41% marginal.

A similar effect happens at the top of the 0% LTCG brackets. An extra $100 of ordinary income would be taxed (MFJ) at 12% federally, however, simultaneously it pushes $100 of LTCG income from 0% bracket to 15% bracket, so you end-up paying $27 federal tax. Referred to as the shadow or ghost 27% bracket.

 

[SecondCor521]

The equation is incomplete. It should be (.22*.85*$social security) assuming they would still be in the 22% bracket.
So they would pay 18.7% tax on every dollar of SS, up to the 24% bracket.

That's the increase in taxes on the dollar of Social Security that becomes taxable. There is also 22% of income tax (in this case) on the added dollar of income that was added to the other taxable income which caused that extra dollar of SS to become taxable. In this case, that other dollar comes from the dollar that would have been taxed except for the fact that the OP's friend made a deductible IRA contribution (which is an adjustment to income). 22% + 18.7% = 40.7% ~= 41%.

BigGun, Dtail, and pb4uski are correct in how it works. If you want to see for yourself, just go play with any reputable tax program. There are also similar types of things with ACA PTC and FAFSA EFC/SAI. In my own case, in 2022 I went from a 0% shadow tax bracket to approximately 49% tax bracket due to these types of things. I realized up through that 0% bracket but stopped when that next $1 was taxed at 49%.

 

[cathy63]

I think I can do the same but with a 457b account.
I received my last paycheck and vacation buyout in January 2022. Doesn’t that qualify me?

If it doesn’t then I also worked for a few months for a nonprofit.
Does anyone know if I can contribute to my 457b account based on that?
Obviously I can google but it seems to get me a lot of information that I don’t need. [emoji23]

I don't think you can contribute to a former employer's 457b plan. Wouldn't that kind of contribution normally show up on your W-2 as a reduction of the amount in box 1, and surely you've already received your W-2 for last year.

You may be eligible to make a deductible contribution to a tIRA though. Since you had a retirement plan at work: if you're single, your AGI has to be less than $68K to take the full IRA deduction; if you're married, AGI has to be less than $109,000.

 

[Irishgirlyc58]

I don't think you can contribute to a former employer's 457b plan. Wouldn't that kind of contribution normally show up on your W-2 as a reduction of the amount in box 1, and surely you've already received your W-2 for last year.

You may be eligible to make a deductible contribution to a tIRA though. Since you had a retirement plan at work: if you're single, your AGI has to be less than $68K to take the full IRA deduction; if you're married, AGI has to be less than $109,000.

Oh shoot. It has to come out of the pay I received back in January 2022. I was so used to contributing through my employer that I never really thought about that the fact that they won’t take contributions from individuals.
Thanks for the information. I really appreciate it.

I am single and I made over $68,000.

 

[timbervest]

The mechanics are that an extra $100 of ordinary income simultaneously pushes hitherto untaxed SS $100 into taxable. The net effect is that $100 plus $85 (only 85% of SS $100 is taxable) = $185 increase in taxable income. At 22% that comes to $40.70. So, $100 of added income increased the tax bill by $40.70. Close enough to be 41% marginal.

A similar effect happens at the top of the 0% LTCG brackets. An extra $100 of ordinary income would be taxed (MFJ) at 12% federally, however, simultaneously it pushes $100 of LTCG income from 0% bracket to 15% bracket, so you end-up paying $27 federal tax. Referred to as the shadow or ghost 27% bracket.

Thanks for the clarification.

 

[VanWinkle]

I have a middle income high school friend whose income taxes I have done for many years.

When I did his 2022 return he owed about ~$1,500 where he normally gets a ~$500 refund. So why?

Well, he started SS in late 2021.. only had a month of SS income in 2021 so the impact was negligible. However, in 2022 he had not only a full years worth of SS but he also worked a full year, retiring in December. He had planned to retire earlier in 2022 but kept deferring it.

There was no SS penalty because he is past his FRA, but he did get whacked on taxes because his earnings caused his SS to be 85% taxable... so his marginal tax rate was 41% (22% * 1.85).

However, we were able to have him do a $7,000 tIRA contribution and he'll get a ~$2,100 tax benefit, changing his ~$1,500 due to a ~$600 refund.

Since he stopped working at the end of 2022 his only income in 2023 will be SS and a rental he has that is nil after depreciation... so he can withdraw the entire $7k and interest plus withdraw some more from his 401k without paying any taxes at all.

Funny thing. He is a bit of a neanderthal and unwilling to do anything on the internet so he went to his friendly local savings bank to do the tIRA. I had told him to do the shortest thing available since he would be withdrawing it shortly. The shortest thing available was a 6-month CD that pays 1%. I told him that 6-month brokered CDs and US Treasury Notes are paying 5.1-5.2% so if I was making 4.1-4.2% on a customer I would be very friendly too.

To boot, he has savings there at 0.1%! I have a feeling that there is a boatload of benign neglect money in demand deposits in the banking system.

While I didn't have him do it, I think I could have had him make the contribution today as a 2022 contribution and then withdraw it tomorrow as a 2023 withdrawal and return it to his savings account and he still would have qualified for the tax benefit which I think would be pretty cool... a $2,100 tax benefit for less than an hour's worth "work".

Great story about the power of knowledge when doing taxes. I commend you on the assistance you gave to your friend.

VW

 

[londo]

Due to vacation payout and underestimating her SS, she ended up with much more income than she expected and was just barely over 400% of the FPL, so the first pass at her tax return had her paying back ~$2900 of advanced premium tax credit.

By putting $500 in an IRA for 2022, her income dropped below 400% FPL so her repayment was capped at $1400.

This seems to imply that the ACA 400% FPL cliff is back for 2022. But it's not - the 8.5% cap applies for income over 400% FPL. So being just over or just under 400% FPL has negligible effect. See table 2 "applicable figure" on form 8962 instructions for confirmation. I'm curious what tax software was used for this "first pass" that showed otherwise?

 

[SecondCor521]

This seems to imply that the ACA 400% FPL cliff is back for 2022. But it's not - the 8.5% cap applies for income over 400% FPL. So being just over or just under 400% FPL has negligible effect. See table 2 "applicable figure" on form 8962 instructions for confirmation. I'm curious what tax software was used for this "first pass" that showed otherwise?

There are two different caps involved.

The first is whether a taxpayer is entitled to any ACA credit above 400% of FPL. This cap has been suspended via recent legislation through the end of 2025.

The second is how much a taxpayer who received too much APTC has to repay. These repayment caps have been in place for a while and were unchanged by recent legislation.

The second cap is handled on line 28 of Form 8962. It sounded to me like the previous poster was referring to this second cap.

For a taxpayer with excess APTC, getting under 400% of FPL affects the amount which goes on line 28. The difference could easily be significant.

 

[londo]

Ah, that makes sense - thanks!

 

[Koolau]

I may be missing something but can you explain this? I can't see anyway anyone would have a marginal tax rate of 41%.

If anything the 85% of his SS might kick him into the 24% bracket but not 41%.

Wish I could lay my hands on my copy of "THE COMING GENERATIONAL STORM" by Kotlikoff and Burns. IIRC they show situations where marginal rates can approach 100% under very specific circumstances (IIRC it had to do with the spouse taking a j*b and the additive effects of tax bracket, SS withholding vs eventual payback and others "gummint gotchas.") Technically, it might not have been marginal tax rate as such - more a calculation of how much was actually gained (almost zero) by apparently obtaining more money. Also, IIRC the calculation did not include things like extra clothing allowance, dry cleaning, child care, etc. - just arcane effects of taxing policy. YMMV

 

[pb4uski]

I may be missing something but can you explain this? I can't see anyway anyone would have a marginal tax rate of 41%.

If anything the 85% of his SS might kick him into the 24% bracket but not 41%.

The mechanics are that an extra $100 of ordinary income simultaneously pushes hitherto untaxed SS $100 into taxable. The net effect is that $100 plus $85 (only 85% of SS $100 is taxable) = $185 increase in taxable income. At 22% that comes to $40.70. So, $100 of added income increased the tax bill by $40.70. Close enough to be 41% marginal.

A similar effect happens at the top of the 0% LTCG brackets. An extra $100 of ordinary income would be taxed (MFJ) at 12% federally, however, simultaneously it pushes $100 of LTCG income from 0% bracket to 15% bracket, so you end-up paying $27 federal tax. Referred to as the shadow or ghost 27% bracket.

Big Gun (and others) nailed it. The 41% is 185% of 22%, rounded up.

With no IRA contribution, tax was $5,905; wth $1,000 tIRA contribution, tax was $5,498; change in tax on $1,000 contribution was $407; ego the 40.7% rate.