Social Security Can Raise Your Taxes – Motley's Fool

There are still a few months to go before the tax season begins, but for fixed-income retirees, any reference to a higher tax bill requires careful pre-planning. For the most part, typical US retirees generally have modest incomes and are therefore in relatively low tax brackets. But one thing that many people do not realize is that even after retirement, a surprising tax rule could actually cause them to pay much higher taxes, with marginal rates above 40% in certain circumstances.

This is due to the way in which social security benefits are taxed. Many people are shocked to learn that the IRS sometimes claims a reduction in their monthly Social Security retirement checks, but the worst aspect of the current Social Security Tax Act is that for some groups concerned with the tax rates are still higher than what are currently paying the richest American taxpayers.

Taxes and social security

Everyone should not pay tax on their social security, but if you earn more than a certain amount of income, a portion of your benefits may become taxable. In order to determine if you must pay a tax on your social security income, you must use your total income from sources other than Social Security and add half of the benefits you received from Social Security during the year. year. You will then use this total amount to determine if your accounting income is greater than the threshold shown below.

Data source: IRS.

As you can see above, if your income exceeds the amount shown in the middle column, up to half of your social security benefits are added to your taxable income for the purposes of the IRS. Rise above the figure shown in the right-most column above, and the figure of half to include the benefits in taxable income reaches a maximum of 85%.

How Social Security Tax Can Produce Huge Marginal Tax Rates

The problem occurs when you consider the actual application of this rule. For example, suppose that a single person earns $ 1,500 per month in Social Security and makes monthly withdrawals of $ 3,000 from a traditional IRA or 401 (k) account. In this case, the accounting income would be $ 36,000 plus half of a total of $ 18,000 or $ 45,000. This is well above the maximum threshold of 34,000 USD for taxing social security. In this case, the result would be that $ 13,850 of the $ 18,000 benefit would be subject to tax.

Now let's take a look at a similar situation, except that the person incurs an additional $ 1,000 withdrawal from the IRA once to pay for unexpected expenses. This brings the accounting income to $ 46,000, and $ 14,700 in benefits would be included in taxable income. In other words, the withdrawal not only generated $ 1,000 of additional taxable income because of the IRA rules, but it also added $ 850 of taxable income because more security benefits were included.

Imposing $ 1.85 for every dollar of additional withdrawals to the IRA actually increases the marginal rates by 85%. Therefore, if you are in the 22% tax bracket at retirement, this increase would increase your effective marginal tax rate to 40.7%. Even for those who are in the lower tax bracket, the impact can have a significant impact on your after-tax income.

Manage your tax liability

The key here is that retirees have at least some control over the money they withdraw from their retirement accounts to the tax benefit. By becoming aware of the income limits that retirees face in determining whether social security benefits will be taxable, you can hope to better make withdrawals from IRA and find ways to stay below the thresholds at which more and more of your benefits will be taken away by the IRS.