By Scott Burns

Q. In a recent column about spendable income, you commented on the taxation of Social Security benefits. You said that "for most people, the amount not taxed will be much larger." Would you elaborate a bit on that, please? My wife and I are 75 and 82 with total Social Security benefits of $43,725. Beginning this year, our total annual joint income is $72,500— entirely from Social Security and stock dividends. —J.S., by email

A. Part of the reforms introduced by the Greenspan Commission in 1983 was the taxation of Social Security benefits. From that time forward Social Security benefits would be subject to taxation when— and if— your income from different sources exceeded certain amounts. The formula for the taxation of benefits was not indexed to inflation. A later Congress added a second, and higher, level of taxation.

Over time, inflation has caused an increasing proportion of Social Security recipients to have to pay income taxes on their benefits. That said, most Social Security benefits are not taxed. In the most recent Trustee report, for instance, $659.6 billion was paid out in benefits but only $20.8 billion was collected in taxes in 2009.

The basic formula for a joint return calls for your Social Security benefits to start being added to your taxable income when ½ of your Social Security benefits plus other income exceeds $32,000. In your case, with $28,775 of income from other sources, you exceed the $32,000 threshold by $18,537 ($28,775+ ½ of $43,725 less $32,000=$18,637).

The first $12,000 of the $18,637 over the threshold causes $6,000 of Social Security benefits (50 percent) to be added to your taxable income. The remaining $6,637 causes an additional $5,641 (85 percent of $6,637) to be added to your taxable income. As a consequence, $11,656 of Social Security benefits must be added to your taxable income. It’s a subtle tax, one you might never see if you have your tax return done for you.

As your income rises the amount of your benefits that will be added to your taxable income will increase until you reach a maximum of 85 percent of your benefits added to your taxable income. Because the formula isn’t indexed (one of the very few items in the tax code that is not indexed to inflation) retirees will pay taxes on more and more of their benefits even though the purchasing power of their benefits will be constant.

If you think this is bad for you, just wait. It will be a real monster for your children.

This is the kind of weasel-cowardice that our legislators bring to the table when they write tax law. They knew that few in office in 1983 would still be in office when inflation started to make the tax bite. It is the same kind of garbage that is built into the hokey financing of the medical reform bill passed last year, a bill that adds entitlements while cutting benefits to Medicare and payments to doctors.

As I have pointed out many times, the taxation of Social Security benefits is a bi-partisan hosing of the voting and working public. The original taxation of benefits was introduced during the Reagan administration. The second level of taxation was introduced during the Clinton administration. You may now thank both parties for their devoted service.

Q. I have two variable annuities with Trans America. Because of the expenses I now realize that this was not a great investment. I have $100,000 in a taxable variable annuity and $200,000 in a 401(k) account. The surrender charge is $350 for both. My initial investment was $50,000 in the taxable account and $109,000 in the 401(k). I am 62 and on Social Security. My spouse is still employed and earns a six figure income. We do not need the money, but I would like to know: What is the best alternative? —R. A., Bee Cave, TX

A. Total annual expenses for Trans America variable annuity products— insurance plus sub-account expense ratios— average about 2.6 percent for domestic equity funds, according to the Morningstar database. You can reduce expenses substantially by moving to a lower cost annuity using a 1035 exchange for the taxable account. Doing an exchange would avoid realizing income tax liabilities on the $50,000 of accumulated gains. The lowest cost product in the industry is the no-load Vanguard variable annuity. It has total costs of about 0.65 percent. The annuity in your 401(k) plan can be liquidated and moved to a rollover IRA without tax consequences. Changes like this should always be checked with your CPA or tax preparer.