If you’re retiring soon and will be receiving Social Security benefits, or are already retired, you might be hit with an unexpected tax whammy when you file your personal tax return.
Watch out for the “tax torpedo.” This is the name given to the increase in our top marginal tax rate under the complex calculation for Social Security benefits.
Frequently, the tax torpedo affects retirees who must take required minimum distributions (RMDs) from their qualified plans, like 401 (k) plans and IRAs.
The tax you owe on Social Security benefits depends on the amount of your “provisional income” (PI) for the year. PI is the total of your adjusted gross income (AGI), tax-exempt interest income and one-half of the Social Security benefits received. For example, if your AGI is $80,000 and you collect $12,000 in tax-free municipal bond interest and $16,000 in Social Security benefits, your PI is $100,000 ($80,000 plus $12,000 plus $8,000).
There are two tiers for taxing Social Security benefits.
Tier #1: If your PI is between $32,000 and $44,000 ($25,000 and $34,000 for single filers), you must pay tax on the lesser of one-half of your Social Security benefits or 50% of the amount by which your PI exceeds $32,000 ($25,000 for single filers).
Tier #2: If your PI is absolve $44,000 ($34,000 for single filers), you must include in taxable income 85% of the amount by which PI exceeds $44,000 ($34,000 for single filers) plus the lesser of the amount determined under the first tier or $6,000 ($4,500 for single filers). Caveat: In no event can more than 85% of your benefits be taxed. The aforementioned thresholds aren’t indexed for inflation, so you must cope with these relatively low thresholds year after year. And, if that wasn’t bad enough, here’s another problem: You’re the prime target of the tax torpedo once you start taking RMDs from qualified plans and IRAs. Generally, you must begin taking RMDs after age 70 ½ .
Example: For simplicity, let’s say you’re a single filer who is normally in the 22% tax and you are required to withdraw a $1,000 RMD for the 2020 tax year. First, the tax on the RMD is $220, but the $1,000 addition to PI can cause up to an extra $850 of your Social Security benefits to be subject to tax.
As a result, the effective incremental federal income tax on your $1,000 RMD is $407 (22% of $1,850). So, the tax torpedo increases your marginal tax rate from 22% to 40.7% – almost double. How can you fend off the tax torpedo?
- Assess your current exposure. Determine if the tax torpedo could blow up your tax return.
- Look ahead. Before you start taking RMDs, you might convert a traditional IRA to a Roth where future payouts are tax free five years after the conversion. In the same vein, you might arrange other no-tax or low-tax payouts.
- Consider your Social Security status. The tax torpedo is a key factor in determining when to begin receiving benefits, but it’s not the only one.
Tip: Meet with your tax professional to determine the best approach for your situation.
Small Business Tax Strategies
July 2021