By Justin Fundalinski, MBA | June 21, 2018
In a previous article I discussed in detail the intricacies of how Social Security gets taxed. In some cases no Social Security income is taxable while in others up to 85% of Social Security income is taxable. Because of the unique way Social Security income phases into taxation, there is a “window” when every additional dollar from other income sources drags more Social Security into taxation. During this window, since every additional dollar of income creates more taxable income (in the eyes of the IRS), the effective tax rate on this other income sky rockets. This effect is often referred to the Tax Torpedo and offers unique retirement planning opportunities.
How does the tax torpedo work?
Unfortunately, this is a very difficult concept to grasp, however if you think about with an example it is much easier to understand.
Remember, zero to 85% of your Social Security can be taxed, but what determines if none or some is taxed depends on how much other income you have. For this example, assume you have Social Security income and other income that is just low enough so that none of your Social Security income is being categorized as taxable income.
Now, imagine you need to dip into your IRA assets for an unexpected $1000 expense. At this point, most people would assume that this withdrawal will simply cause them to have an additional $1,000 of taxable income; however, this is far from the truth. Because of how Social Security phases in as taxable income, this $1,000 withdrawal from your IRA causes $500 of your Social Security to magically be taxable. So, now instead of paying tax on $1,000 at your marginal tax rate, you now must pay tax on $1,500 at your marginal tax rate.
It gets worse too. The above example essentially dragged in 50 cents of Social Security income into taxation for every $1 of additional other income. As you add more income to the equation it will eventually hit a breakpoint where 85 cents of Social Security income is dragged into taxation for every $1 of additional income. Fortunately, the maximum 85% of your Social Security will eventually be subject to taxation and the window will close on this tax torpedo.
What will my effective tax rate be for each additional dollar of other income?
As with most things in life the answer to this question is, it depends. It depends on what breakpoint you are at (50 cents or 85 cents of Social Security being dragged in as described above), as well as what your marginal tax rate is. However, I can quickly summarize the effective rates depending on all these variables.
- If 50 cents of Social Security is being dragged in for every dollar of other income this will increase your tax rate by 50%. That is, if your marginal tax bracket is 0%, 10%, or 12% then each dollar of new income will now be taxed at 0%, 15%, 18%, respectively.
- Similarly, if 85 cents of Social Security is being dragged in for every dollar of other income this will increase your tax rate by 85%. That is, if your marginal tax bracket is 0%, 10%, 12% then each dollar of new income will now be taxed at 0%,19%, 22%, respectively.
Yikes! It is very possible to pay a 22% tax on an IRA withdrawal when you are in the 12% bracket. How can this be fair? Think about it like this, Social Security is still tax advantaged, however, it gets ugly during the window of income when these benefits get phased into taxation. It’s better to have tax advantaged income than 100% taxable income, right? Also, armed with this knowledge a savvy pre-retiree or early retiree can potentially take advantage of how these tax rules work.
How can I plan around the tax torpedo?
There are many ways to plan around the tax torpedo. For some, there maybe minimal opportunity and those people simply must deal with the fact that 85% of their Social Security will be taxed. For others, a strong and disciplined IRA distribution and Roth conversation strategy coupled with appropriate Social Security claiming strategies can save thousands in taxes as well as increase the amount of tax advantaged income generated from Social Security. If you would like to discuss in more detail how the tax torpedo could affect you personally, please reach out to our office.