Would your clients like to pay almost twice their federal tax rate? Probably not. Yet this is exactly what might happen to many baby boomers as they start collecting Social Security benefits. The unique manner in which the benefits are taxed means that recipients may pay tax at marginal rates of up to 1.85 times the federal income tax rate for their income level.

To understand how this happens, let’s start with the definition of income. The IRS requires a unique calculation called combined income, which is used specifically for Social Security taxation calculations. Combined income is the sum of adjusted gross income (form 1040, line 37, for you tax hounds), tax-free income, half of Social Security income and a few less common add-backs.

Combined Income = AGI + tax-free income + ½ of SS income + minor add-ons

If combined income is below certain limits, no Social Security income is taxed, and all income comes in at normal marginal rates.

Above \$32,000 for joint filers and \$25,000 for singles, however, a convoluted interplay of factors leads to the alarmingly high rates.

THE TAX TRAP

Consider the example of a married couple with \$40,000 of annual Social Security income. Half of that income equals \$20,000. This couple only needs another \$12,000 of other income, whether from qualified RMDs, tax-free bonds, interest and other sources, to hit the \$32,000 joint-filer threshold and with it, the tax trap.

There’s nothing strange about \$1 of other income raising AGI and, by extension, taxable income, by \$1. But in the tax trap, that \$1 simultaneously moves a portion of a dollar of previously untaxed Social Security income onto the taxable ledger. For joint filers, that portion is 50% between \$32,000 and \$44,000 of combined income.

The net effect is that one dollar of extra income adds \$1.50 to taxable income, thereby boosting marginal rates to 150% of normal for this dollar. The couple’s marginal rate, normally 10% below \$18,000 taxable income, becomes in effect 15% (10% x 1.5). Above \$18,000 of taxable income, their normal rate of 15% becomes 22.5% (15% x 1.5).

IT GETS WORSE

Once the couple’s other income exceeds \$24,000 (\$44,000 of combined income), an extra dollar of income will push 85% of an extra dollar of Social Security into taxable income. The special marginal rate now equals 185% of the normal marginal tax rate. Furthermore, a normal 15% marginal rate has become effectively a 27.75% (15% x 1.85) rate.

The chart below shows the effective marginal rates for the couple in our example at different levels of other income. The marginal rate shifts from 150% at \$12,000 of other income, to 185% at \$24,000 other income and back to 100% at \$58,000 of other income.

A maximum of 85% of all Social Security income may be taxed according to the IRS. For our couple, this would be \$34,000 of Social Security income, and would occur if combined income reached \$78,000 (equivalent to other income of \$58,000 in the chart).

For taxpayers with higher Social Security income, the entire graph will shift to the left, and they would fall in the tax trap at lower levels of other income. For those with lower Social Security income, the entire graph will shift to the right.

The chart does not account for adjustments used to calculate taxable income. If one assumes that joint filers take \$8,000 for two personal exemptions and the standard deduction of \$12,600, the first taxable dollar occurs at approximately \$18,000 of other income. The couple’s first taxable dollar, therefore, would be taxed at 15%, completely bypassing the 10% bracket.

To generally summarize:

• If combined income for joint filers is less than \$32,000, there’s no effect on marginal tax rates.
• If combined income for joint filers is greater than \$44,000 plus 85% of Social Security, there’s no effect on marginal tax rates.
• Between these two, clients are in the tax trap, paying either 150% or 185% of their marginal tax rate on additional taxable income.

WHAT CAN BE DONE?

While it can shock taxpayers that they may be paying almost twice the marginal tax rate, there are strategies to mitigate the trap’s impact. Grouping the sale of investments that produce gains and other appreciated assets in one year, for instance, can help. If one is already close to that 185% marginal tax bracket, these sales will trigger negligible extra tax consequences in that year. For the following year, combined income would be lower, meaning less income would be taxed at higher tax-trap rates.

Paul Norr is a certified financial planner with Bucks County Financial Planning Group in Thousand Oaks, Calif.

Paul Norr

Paul Norr is a certified financial planner with Bucks County Financial Planning Group in Thousand Oaks, Calif.