If you're drawing Social Security and you take additional income from your IRA or have significant Capital Gains, you may notice a substantial increase in your effective tax rate. You're suddenly paying more taxes than you may have expected.
What happened? You probably got hit by the Social Security Tax Torpedo!
The Social Security Tax Torpedo is a nasty tax spike that often impacts people receiving Social Security income.
It's nicknamed a torpedo because the increased effective tax rate only lasts while Social Security income is taxed. It starts when Social Security first becomes taxable and lasts until all Social Security income has been taxed. Like a torpedo, it strikes, and then it's gone.
To understand, let's do a quick review of how Social Security income is taxed:
Social Security is taxable based on income level.
"Combined income" is the basis of the calculation. The IRS defines Combined Income as:
Adjusted gross income + Nontaxable interest + ½ of your Social Security benefits
Social Security is taxable when:
- Individual filer with combined income
- between $25,000 and $34,000; income tax applies on up to 50 percent of benefits.
- over $34,000, up to 85 percent may be taxable.
- Joint filer with combined income
- between $32,000 and $44,000, income tax applies on up to 50 percent of benefits.
- over $44,000, up to 85 percent may be taxable.
Thus, consider a hypothetical retiree who has an income of $38,000 from an IRA and Social Security Income of $25,000. They're in the 22% tax bracket.
If they take an additional $1,000 from their IRA, that extra income has an effective tax rate of 40.7%, not the expected 22%.
This is because there's a tax on the $1000 and on 85% of $1000 of Social Security income. For every dollar of income drawn during this interval, $1.85 is taxable.
Can the SS Torpedo be avoided?
There are strategies out there, but be careful the cure isn't worse than the tax itself.
One idea is to delay Social Security until age 70, if possible.
Postponing Social Security may avoid the torpedo until age 70. Still, at that point, the income will be more significant and, therefore, the tax hit's ongoing size.
Another idea is to make small annual conversions to a Roth IRA while delaying Social Security and then make withdrawals from the Roth after age seventy.
Incremental Roth conversions are a good idea. Roth IRAs add flexibility to tax planning.
I also see a negative here: By converting, you're paying taxes earlier and depleting the most tax-advantaged asset.
Be aware of the SS Torpedo and prepare as much as reasonably possible. But you know what they say about paying taxes.
In the end, take solace that it's better to pay taxes on income than have no income at all.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
This information is not intended to be a substitute for specific individualized tax advice. We suggest you suggest your specific tax issues with a qualified tax advisor.