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Social Security’s Achilles Heel: The Tax Torpedo

How does the Social Security administration manage to provide benefits to people most in need? By deploying the “tax torpedo.” 

This (often unexpected) tax bite is aimed at retirees that still have sources of taxable income (such as Required Minimum Distributions (“RMDs”) from retirement plans or regular earned income.

There are some moving parts here, so it’s helpful to see how this complex law works. First, think about what is deemed “provisional income.” This includes all forms of traditional income, tax-exempt interest (and other income that is not typically taxed) along with 50% of your Social Security income.

If all of that is less than $25,000 (for a single taxpayer), then the Social Security earnings are untaxed. What about someone that has provisional income of more than $25,000 but less than $32,000? Well, that person pays 50% of the difference between $25,000 and $32,000.  Above $32,000, and a hefty 85% of Social Security benefits are taxed.

(Married taxpayers have higher thresholds, but the tax torpedo still comes quite early in the game). 

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In response, many people look to pull forward their income into their 60’s. As one example, funding a Roth IRA, or making Roth IRA conversion, can lower the amount of RMDs you must take once you turn 70 ½. This issue is yet another reason in favor of delaying collecting Social Security until you must, and instead drawing down the funds in a traditional IRA or 401K during your 60’s. 

Looking to do the math on that approach? Know that your Social Security benefit rises by 8% with every year you wait. That’s a lot more predictable than long-term investments in the stock market. 

Another option is to consider Qualified Charitable Distributions (QCDs). These enable to donate some or all of your RMDs to the charity of your choice. An added benefit of this move is that it can lower your income thresholds to avoid the extra tax due that may be charged on Medicare Premiums. The Social Security Administration does a fine job of explaining this issue in this document. As the document notes,  higher-income beneficiaries pay higher premiums for Part B and prescription drug coverage.

If you want a more detailed explanation of the tax torpedo, my colleagues at the Financial Planning Association have provided a handy primer