Navigating the Tax Torpedo: The Rising Taxation of Social Security

Many of my clients who retire in their early to mid-60s will find that they are in the 12% marginal federal tax bracket even if they have a considerable nest egg of $1-$5M saved in retirement accounts. This is typically because they are drawing down assets that have already been taxed (cash savings, brokerage accounts, etc.) Because of this, there are significant benefits of tax strategy in the early years of retirement – such as laddered Roth conversions and realizing capital gains at 0%.

For individuals in the 12% marginal tax bracket, a less-discussed aspect of taxes is the Social Security "Tax Torpedo" – a phenomenon where the portion of your Social Security benefits that becomes subject to taxation increases as other income is realized.

The extent to which your Social Security is taxed depends on your provisional income. While this can be tricky to calculate a good rule of thumb is to add the following -

1)     Your adjusted gross income minus any Social Security benefits.

2)     Any tax-exempt interest such as municipal bonds.

3)     Half of your Social Security benefits.

How much your Social Security is taxed depends on where this number lands. It can be anywhere from 0% all the way up to 85% taxed. Note this is not an 85% tax rate, it is your tax rate multiplied by 85% of your benefits.

The “tax torpedo” begins when you start considering other tax strategies in these low-income years. For example, you might be doing a Roth conversion in the 12% marginal tax bracket, but because the Roth conversion increases the rate at which Social Security is taxed, it has a much higher impact on your tax bill than just 12%. This feedback loop is why many consider it a “tax torpedo.” 

Below is an example to illustrate this concept. A couple has $29,000 in IRA distributions and $40,000 in Social Security benefits but only $10,250 is taxable, leading to an AGI of $39,250. After deductions, taxable income is $11,407. They correctly calculate that it is another $78,043 to the top of the 12% tax bracket of $89,450.  

They decide to do a Roth conversion of $78,043. However, they do not account for how this conversion will increase the taxability of their Social Security. Because of this conversion, it made more of their Social Security taxable (85% vs. Previously 25%).

This then made a portion of the Roth conversion taxed at 22%, which raised the effective cost of the conversion to over 18%.

While it may be challenging to completely avoid the Tax Torpedo, there are strategies you can utilize to minimize its impact on your retirement income such as delaying Social Security, managing other sources of income, and tax-efficient withdrawals.

Happy Planning,

Alex

This blog post is not advice. Please read disclaimers.