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SFeb 11, 2003

How The Tax Torpedo Hits

Portfolio managers call them "torpedo stocks." They are the disastrous stock that can sink the performance of a portfolio. Well, allow me to introduce the Torpedo Tax, the single tax that can reduce your retirement standard of living. It's the tax on Social Security benefits.  

It is experienced as a high tax rate on income other than Social Security. Economists call this the "marginal tax rate." To them, this means the rate of tax paid on the last dollar of income. To most human beings, the phrase is meaningless. Indeed, many of the people who responded to my recent columns about this tax asked how a tax on benefits could produce a tax rate of 50 percent.

The answer is simple, but not obvious.

Suppose you are in the 27 percent tax bracket, which means that you'll pay $270 in income taxes if you receive an additional $1,000 in income. When you add this $1,000 of income, you may also trigger the inclusion of $500 or $850 of Social Security benefits in your tax calculation.

As a consequence, each additional $1,000 of other income will trigger either $405 ($270+$135) or $500 ($270+$230) of additional income taxes. That's like having a tax rate of 40.5 percent or 50 percent on the additional $1,000. To put those rates in perspective, the top tax rate is 38.6 percent, levied against taxable income over $307,050.

The best way to see how the tax hits is to demonstrate it. So I've done that, assuming a two earner couple with lifetime average incomes. An average earner who retired this year at 65 would receive $13,900 in Social Security benefits. The average earner spouse, retiring at 62, would receive $11,360 in Social Security benefits.   Together they receive $25,260 in Social Security benefits.

Their tax bill, as other income rises from $19,000, is shown in the table below.  

If they have about $46,000 in income beyond their Social Security benefits, each additional $1,000 of income increases their federal income tax bill by 50 percent. At a cash income just over $70,000 they are paying taxes at higher rates than other people whose taxable income is at least $307,050.

  
The Tax Torpedo: Starting To Hit Average Workers
Calculation of Federal income taxes due for a new retiree couple with $25,260 in Social Security benefits.
Other Income Federal Income Tax S.S. taxable Tax Increase Marginal Rate Average Tax Rate Cash Income

$19,000

$428

$0

na

na

1.0%

$44,260

$20,000

$558

$315

$130

13.0%

1.2%

$45,260

$21,000

$708

$815

$150

15.0%

1.5%

$46,260

$22,000

$858

$1,315

$150

15.0%

1.8%

$47,260

$23,000

$1,008

$1,815

$150

15.0%

2.1%

$48,260

$24,000

$1,158

$2,315

$150

15.0%

2.4%

$49,260

$25,000

$1,361

$2,815

$203

20.3%

2.7%

$50,260

$26,000

$1,586

$3,315

$225

22.5%

3.1%

$51,260

$27,000

$1,811

$3,815

$225

22.5%

3.5%

$52,260

$28,000

$2,036

$4,315

$225

22.5%

3.8%

$53,260

$29,000

$2,261

$4,815

$225

22.5%

4.2%

$54,260

$30,000

$2,486

$5,315

$225

22.5%

4.5%

$55,260

$31,000

$2,711

$5,815

$225

22.5%

4.8%

$56,260

$32,000

$2,966

$6,536

$255

25.5%

5.2%

$57,260

$33,000

$3,244

$7,386

$278

27.8%

5.6%

$58,260

$34,000

$3,521

$8,236

$277

27.7%

5.9%

$59,260

$35,000

$3,799

$9,086

$278

27.8%

6.3%

$60,260

$36,000

$4,076

$9,936

$277

27.7%

6.7%

$61,260

$37,000

$4,354

$10,786

$278

27.8%

7.0%

$62,260

$38,000

$4,631

$11,636

$277

27.7%

7.3%

$63,260

$39,000

$4,909

$12,486

$278

27.8%

7.6%

$64,260

$40,000

$5,186

$13,336

$277

27.7%

7.9%

$65,260

$41,000

$5,464

$14,186

$278

27.8%

8.2%

$66,260

$42,000

$5,741

$15,036

$277

27.7%

8.5%

$67,260

$43,000

$6,019

$15,886

$278

27.8%

8.8%

$68,260

$44,000

$6,296

$16,736

$277

27.7%

9.1%

$69,260

$45,000

$6,709

$17,586

$413

41.3%

9.5%

$70,260

$46,000

$7,208

$18,436

$499

49.9%

10.1%

$71,260

$47,000

$7,708

$19,286

$500

50.0%

10.7%

$72,260

$48,000

$8,207

$20,136

$499

49.9%

11.2%

$73,260

$49,000

$8,707

$20,986

$500

50.0%

11.7%

$74,260

$50,000

$9,112

$21,471

$405

40.5%

12.1%

$75,260

Source: Scott Burns's calculations, done with Turbotax 2002.
  

Query: Should we make a fuss?

Maybe not. Since the pre-retirement earnings of an average earner couple was about $70,000, they probably won't hit the 50 percent marginal tax.   The retiree couple also pays less in income taxes than a working couple pays. On a cash income of $45,260, the retiree couple pays $3,538 less in federal income taxes than the working couple pays.   The retired couple still pays $1,321 less in federal income taxes at $75,260.

Unfortunately, this isn't a static problem. In 1983, when the $25,000 and $34,000 thresholds were set very few paid the tax. With the thresholds un-indexed, the Torpedo Tax bites more each year.

Now ask a simple question.

How much of the money in your tax deferred account will be yours to spend? Before 1983, most retirees faced top tax rates the equivalent of 15 or 27 percent. In effect 73 to 85 cents of every retirement account dollar was theirs to spend.

No more. Social Security benefit taxation can reduce the value of tax-deferred accounts to 50 to 78 cents on the dollar.

Next Tuesday: How To Exchange 73 cents for 50 cents.

Filed Under: Government, Taxes & Other Disasters, Social Security