Social Security tax Torpedo

[JBTX]

I always find this visual representation helpful

https://www.bogleheads.org/w/images/6/6a/SSHeatMapMFJ2023.png

I have also created a lifelong spreadsheet model that factors this stuff in, but I haven’t really played a lot with it.

The visual representation above directionally guides what we are doing, but there are quite a bit of variables in our future such that modeling with any precision is difficult. Also, the representation is as of today (I assume). The social security taxation brackets are not inflation adjusted so that map will change through time. If tax rates revert in 2026 they will change again.

We are about 50/50 Roth / Traditional. We may do some more modest conversions, and would like to be mostly Roth by the time we die, such that we leave Roths in trusts for our kids, but at the same time want to keep enough traditional while we are alive such that if we ever dip into a lower bracket and/or have significant medical deductions we can take advantage of it.

 

[qwerty3656]

I always find this visual representation helpful

https://www.bogleheads.org/w/images/6/6a/SSHeatMapMFJ2023.png

I have also created a lifelong spreadsheet model that factors this stuff in, but I haven’t really played a lot with it.

The visual representation above directionally guides what we are doing, but there are quite a bit of variables in our future such that modeling with any precision is difficult. Also, the representation is as of today (I assume). The social security taxation brackets are not inflation adjusted so that map will change through time. If tax rates revert in 2026 they will change again.

We are about 50/50 Roth / Traditional. We may do some more modest conversions, and would like to be mostly Roth by the time we die, such that we leave Roths in trusts for our kids, but at the same time want to keep enough traditional while we are alive such that if we ever dip into a lower bracket and/or have significant medical deductions we can take advantage of it.

So does that chart show the marginal tax rate for married filing jointly? Also, why are you using a trust to pass Roth IRAs to your kids? Is there any benefit over just naming them beneficiaries?

 

[Montecfo]

I am not drawing SS at this point.
I never planned on favorable tax treatment on SS. In fact I never planned on SS.

So no tax "torpedo". I do watch IRMAA tiers.

 

[Telly]

Spouse has a good (and very rare) pension, so we always knew 85% of our SocSec would be taxed. I took mine at 67. He'll take his at age 70, but he gets socked with the WEP so he'll lose 60% of his SocSec benefit right off the top.

So he's only going to receive a few hundred $$$ monthly. Altho I'd better check with our tax advisor to be sure the income taxes come after the WEP, and not before!

Haha, no worry. He'll get WEP'd first, and then taxed on what SS income is left.

 

[TheWizard]

I am not drawing SS at this point.
I never planned on favorable tax treatment on SS. In fact I never planned on SS.

So no tax "torpedo". I do watch IRMAA tiers.

It depends. If you're doing Roth conversions at least as big as your projected SS + RMD, then you'll be able to transition into receiving those income streams when the time comes without a big jump in income and tax...

 

[ERhoosier]

All post tax. That's why for most people about 85% is taxable and 15% is not taxable... the 15% isn't taxable because it is a return of your contributions albeit in an extremely crude and broadbrush way.

Here is the 'official' take on the evolution of taxation of SS benefits.



https://www.ssa.gov/history/taxationofbenefits.html


IMHO this is somewhat misleading because it downplays the fact that the non-taxation of benefits was an INTENDED feature of the Program (benefits could be set lower in part because they were tax-free). Another case showing the Feds can change the taxation of ANY program at any time.

 

[pb4uski]

.... IMHO this is somewhat misleading because it downplays the fact that the non-taxation of benefits was an INTENDED feature of the Program (benefits could be set lower in part because they were tax-free). Another case showing the Feds can change the taxation of ANY program at any time.

Do you have a citation or any evidence to support your assertion that social security retirement benefits were INTENDED to be tax-free? I have never seen anything along those lines and I don't beleive it to be the case. I think you are wrong, but if you have evidence to support that view by all means provide it.

It is true that Congress did not address the taxation of SS benefits in the SS Act and that as a result when retirement benefits first started being paid out that the Treasury Department had to step in an issue a Treasury Ruling. While the Treasury Ruling said that SS retirement benefits were not subject to federal income tax that put the taxation of social security retirement benefits different from other contributory pensions. Finally, in 1979 the Advisory Council said:

The present tax treatment of social security was established at a time when both social security benefits and income tax rates were low. In 1941 the Bureau of Internal Revenue ruled that social security benefits were not taxable, most probably because they were viewed as a form of income similar to a gift or gratuity.

The council believes that this ruling was wrong when made and is wrong today. The right to social security benefits is derived from earnings in covered employment just as is the case with private pensions.

The council believes that the current tax treatment of private pensions is a more appropriate model for the tax treatment of social security, Pension benefits from contributory private pension plans (including those for government employees) are now taxed to the extent that the benefits exceed the employee's accumulated contributions to the plan. Cumulative retirement benefits up to the employee's own total contributions are not taxed because the income from which the contributions were paid was taxable. That part of the benefit representing the employer's contribution and interest income on both the employee's and the employer's contributions is taxed when received.

That thought was later enacted in legislation albeit in a very crude way, initially at 50% and then later at 85%, along with some political concession to reduce ths tax burden on lower income taxpayers.

As a retired CPA, I think the Advisory Council nailed it.... not taxing a portion of social security retirement benefits was wrong to begin with and many years later they corrected it.

 

[Gumby]

You have mentioned this before, and I think your position is a reasonable one.

 

[SevenUp]

I always find this visual representation helpful
https://www.bogleheads.org/w/images/6/6a/SSHeatMapMFJ2023.png

So does that chart show the marginal tax rate for married filing jointly?

Yes, assuming there are no long term capital gains or qualified dividends.

It is part of the Taxation of Social Security benefits - Bogleheads wiki article - see that for details.

If your situation includes long term capital gains or qualified dividends and you haven't reached the total income that makes 85% of your SS benefits taxable, the case study spreadsheet mentioned earlier (and evidently used to generate some of the charts within that wiki article) can be used to show your own situation.

 

[PointBreeze]

It's really going to hit me. Without Roth conversions, I would pay almost no income tax. I can't do Roth conversions until 2025 because I'm using the ACA for health insurance this year and next. So I only have 2025-2031 to do Roth conversions.

My primary issue is having enough non-qualified $$ to pay the taxes on those conversions. Like many of us in my age range, I put way too much into my 403(b), not understanding the tax torpedo. Wish I had put less into the 403(b) and more into my Roth and brokerage , but that is water under the bridge now.

 

[JBTX]

Do you have a citation or any evidence to support your assertion that social security retirement benefits were INTENDED to be tax-free? I have never seen anything along those lines and I don't beleive it to be the case. I think you are wrong, but if you have evidence to support that view by all means provide it.

It is true that Congress did not address the taxation of SS benefits in the SS Act and that as a result when retirement benefits first started being paid out that the Treasury Department had to step in an issue a Treasury Ruling. While the Treasury Ruling said that SS retirement benefits were not subject to federal income tax that put the taxation of social security retirement benefits different from other contributory pensions. Finally, in 1979 the Advisory Council said:


That thought was later enacted in legislation albeit in a very crude way, initially at 50% and then later at 85%, along with some political concession to reduce ths tax burden on lower income taxpayers.

As a retired CPA, I think the Advisory Council nailed it.... not taxing a portion of social security retirement benefits was wrong to begin with and many years later they corrected it.

I think the 50% taxable revision was to reflect that the employer side of the social security contribution was tax deductible to the employer, where as the employee side was not tax deductible to either employer or employee. As to the subsequent 85%, I think that was just a way to try to keep the system solvent. Or perhaps to reflect taxation on inflation gains. I may be wrong on that.

 

[TheWizard]

It's really going to hit me. Without Roth conversions, I would pay almost no income tax. I can't do Roth conversions until 2025 because I'm using the ACA for health insurance this year and next. So I only have 2025-2031 to do Roth conversions.

My primary issue is having enough non-qualified $$ to pay the taxes on those conversions. Like many of us in my age range, I put way too much into my 403(b), not understanding the tax torpedo. Wish I had put less into the 403(b) and more into my Roth and brokerage , but that is water under the bridge now.

You'll be fine, it sounds like.
You can use additional withdrawals from tax-deferred to pay the income tax on Roth conversions.
For example, do a $60,000 Roth conversion and then withdraw $15k additional to pay the tax, something like that.

Looks like you have five years from age 65 to start of SS at 70 to do good-sized conversions. And then another five years until start of RMDs at 75 (?) to do smaller conversions.

After starting RMDs, you'll just have to get comfortable with being a higher income retiree and get proficient at investing excess income in your taxable account...

 

[pb4uski]

I think the 50% taxable revision was to reflect that the employer side of the social security contribution was tax deductible to the employer, where as the employee side was not tax deductible to either employer or employee. As to the subsequent 85%, I think that was just a way to try to keep the system solvent. Or perhaps to reflect taxation on inflation gains. I may be wrong on that.

I think you are half right, on the first part. The 50% that they did in 1983 was a compromise but even at the time that they conceded to 50% they indicated that realistically it should have been more like 85%. From the committee report:

... Estimates by the Office of the Actuary of the Social Security Administration indicate that workers now entering covered employment in aggregate will make payroll tax payments totaling no more than 17 percent of the benefits that they can expect to receive. The self-employed will pay no more than 26 percent on average. Therefore, if social security benefits were accorded the same tax treatment as private pensions, only 17 percent of the benefit would be exempt from tax when received, and 83 percent would be taxable. . . Rough Justice would be done, however, if half the benefit (the part commonly if somewhat inaccurately attributed to the employer contribution) were made taxable. ...

Then in 1993 they went back and changed it:

...The changes introduced by the 1993 amendments were designed to make the treatment of Social Security benefits more closely approximate private pensions--albeit, only for higher-income beneficiaries. To this end, the taxable percentage was set at 85% for these higher-income beneficiaries. New thresholds were added, but only to differentiate those subject to the higher percentage from those still subject to the 50% figure.

In explaining the rationale for these changes, the House Budget Report stated:

"The committee desires to more closely conform the income tax treatment of Social Security benefits and private pension benefits by increasing the maximum amount of Social Security benefits included in gross income for certain higher-income beneficiaries. Reducing the exclusion for Social Security benefits for these beneficiaries will enhance both the horizontal and vertical equity of the individual income tax system by treating all income in a more similar manner."

Thought you are right that by fixing the inconsistency between the taxation of SS and of contributory pensions that the revenue raised helped preserve system solvency and that was a beneficial by-product.

 

[Montecfo]

It depends. If you're doing Roth conversions at least as big as your projected SS + RMD, then you'll be able to transition into receiving those income streams when the time comes without a big jump in income and tax...

Ok. But not seeing the distinction you are making. What "depends"?

 

[TheWizard]

Maybe it doesn't depend.
The idea is to keep close to a level income in retirement, increasing by inflation each year.
I can't tell if that is what you have in front of you or not.

Regardless, there's nothing wrong with being a higher income retiree.
Things could be worse...

 

[Koolau]

Maybe it doesn't depend.
The idea is to keep close to a level income in retirement, increasing by inflation each year.
I can't tell if that is what you have in front of you or not.

Regardless, there's nothing wrong with being a higher income retiree.
Things could be worse...

True. What's aggravating is that we have to mess with it at all. Some of the cliffs and humps and torpedoes are significant and really can't be ignored (well, I can't - ignore them at your own peril.) What a pain.


Got caught one time because I had no idea how much "depreciation recapture" I would have to endure when we sold our rental/house. Went right over the IRMAA cliff. YMMV

 

[Montecfo]

Maybe it doesn't depend.
The idea is to keep close to a level income in retirement, increasing by inflation each year.
I can't tell if that is what you have in front of you or not.

Regardless, there's nothing wrong with being a higher income retiree.
Things could be worse...

The topic was the "tax torpedo". My view is you do not need to keep income level to avoid a "tax torpedo".

But perhaps the torpedo is in the eye of the beholder?

 

[perrytime]

looking at this way, tax torpedo" doesn't seem that bad.

pulling 130k from IRA, married, no SS, tax bill is 13,121
pulling 80k from IRA, married, 50K SS, tax bill is 11,476

I wouldn't delay SS just to avoid torpedo,

 

[TheWizard]

The topic was the "tax torpedo". My view is you do not need to keep income level to avoid a "tax torpedo".

But perhaps the torpedo is in the eye of the beholder?

I guess we need a definition of Tax Torpedo then?
I would say that it's a situation where additional Taxable Income materializes that wasn't totally planned for, resulting in *much higher* taxes for the indefinite future, compared to the past several years.

The classic example is an early retiree living on funds from a taxable account with very low taxes, only to have much higher taxable income when SS and RMDs start.

I would NOT call a situation with sustained high income beyond one's expenses a tax torpedo...

 

[Koolau]

looking at this way, tax torpedo" doesn't seem that bad.

pulling 130k from IRA, married, no SS, tax bill is 13,121
pulling 80k from IRA, married, 50K SS, tax bill is 11,476

I wouldn't delay SS just to avoid torpedo,

BUt in your scenario, it would appear you don't "need" SS, so why not delay it and instead pull out extra tIRA or 401(k) money to reduce RMDs later? Just a thought - we're all different on this, so not a biggie.

 

[USGrant1962]

I guess we need a definition of Tax Torpedo then?
I would say that it's a situation where additional Taxable Income materializes that wasn't totally planned for, resulting in *much higher* taxes for the indefinite future, compared to the past several years.

The classic example is an early retiree living on funds from a taxable account with very low taxes, only to have much higher taxable income when SS and RMDs start.

I would NOT call a situation with sustained high income beyond one's expenses a tax torpedo...

The SS tax torpedo is normally defined as the range where you are paying 40-50% marginal tax rates because taxability of SS is phasing in. Once you are past that income level it is moot. It is the red area in the graphic linked by JBTX in Post #51 above. It is not simply moving into the 22% or 24% bracket because of SS and RMDs - that is just progressive taxation.

Past the torpedo range it is actually better than moot - you only pay tax on 85% of your SS income instead of 100%.

 

[TheWizard]

The SS tax torpedo is normally defined as the range where you are paying 40-50% marginal tax rates because taxability of SS is phasing in. Once you are past that income level it is moot. It is the red area in the graphic linked by JBTX in Post #51 above. It is not simply moving into the 22% or 24% bracket because of SS and RMDs - that is just progressive taxation.

Past the torpedo range it is actually better than moot - you only pay tax on 85% of your SS income instead of 100%.

I'm aware of what you're talking about but I thought we called that the SS taxation HUMP, not TT...

 

[pb4uski]

I've heard it called both but I think hump is probably more accurate... where one's SS taxed is going from zero to 85% your incremental tax rate can get very high.

 

[USGrant1962]

I've heard it called both but I think hump is probably more accurate... where one's SS taxed is going from zero to 85% your incremental tax rate can get very high.

Yea, I've seen the "retirement tax torpedo" phrase used to describe upper income issues of RMDs+IRMAA+NIIT. But for most people this is well past the SS 40%+ marginal taxation phase-in. I think Bob Carlson uses the "retirement tax torpedo" phrase.

There are lots of tax torpedoes in the water - look out!

 

[TheWizard]

The SS hump tax torpedo is not inflation adjusted and therefore is slowly fading away as an issue...