What government gives with one hand, it takes back with the other.

I’m serious. We experience the taxation of Social Security benefits as a tax on money withdrawn from our retirement plans. Many middle-income retirees are now paying taxes on those withdrawals at a 28.25 percent rate. That’s higher than the 15 percent top rate they paid throughout their working careers.

To put that 28.25 percent rate in perspective, 28 percent is the rate couples will pay on taxable incomes over $151,201 this year. (For singles the figure is $90,751.) Retirees with Social Security benefits can pay 28.25 percent on withdrawals from their retirement plans. This can happen when income is well below $100,000.

How did this happen? Simple. Our elected representatives are busy. The left hand writes some laws; the right hand writes others.

The legislation for 401(k) plans traces to 1978, but the real growth of these plans started in the mid-1980s.  That’s about the same time as the 1983 reform of Social Security. That reform put in place a little-noticed provision for the taxation of benefits. Few noticed or discussed the tax provision. It only affected about 3 percent of all retirees, the ones with the most income.

But the tax provision is unusual. It is one of the few provisions in our tax code that is not indexed to inflation. As a consequence, an obscure tax that hit a handful of affluent retirees in 1984 today hits 30 percent of all retirees. And since the law still isn’t indexed, it will hit even more of the next generation.

That’s why I called it “The Tax Torpedo.”

Over the last 30 years the first enemy of our retirement savings plans was high fees. This was particularly true in 401(k) and 403(b) plans.

Here are some examples of the impact of high fees. The source is an Excel accumulation model that I built and use. It covers the career of a 30-year-old worker. The worker saves 6 percent of income and gets raises one percent greater than the two percent inflation rate. She also enjoys a 50 percent employer match and a gross annualized return of eight percent.

  • In an ideal no-fee world, that worker would accumulate 14 years of her final income at age 67. That, with Social Security, is more than enough to retire.
  • Take one percent in fees and the accumulation drops 2.8 years to 11.2 years.
  • Take two percent in fees and the accumulation drops to 9 years, a loss of 5 years of final income.  That loss is a threat to retirement security. But two percent in fees was common 30 years ago. We can still find small 401(k) plans with fees at that level.  Worse, two percent fees remain common in insurance-based 403(b) plans. The plans offered to public school teachers are a prime example.

The good news is that costs for 401(k) plans have been dropping. The use of low-cost index funds has been increasing in both 401(k) plans and IRA accounts.

But as the hazard of high fees drops, the tax hazard is rising. The blow falls on middle-income retirees. Social Security and retirement account income between $48,000 and $96,000 takes the hit.

Why does the burden fall primarily on middle-income retirees?

Simple. Social Security benefits are added to taxable income by a formula. But once 85 percent of all benefits have been added to taxable income, the tax is done. Once done, more income pays taxes at normal rates. Basically, middle-income taxpayers have to run a gantlet of punishing tax rates. People with lower incomes don’t pay the tax. People with higher incomes have already paid it. Inescapably, the taxation of Social Security benefits hits middle-income retirees hardest.

The damage isn’t minor, even if it is smaller than the damage done by high fees. Fees of one percent would cut 2.8 years of final income off the accumulation. But a 15 percent tax rate reduces the accumulation by another 2.1 years. Bumping the tax rate to 28.25 percent subtracts another 1.8 years.

It all makes a difference in coping with the problem of retirement security. The final absurdity in this tax is that it hits retirees so hard. It doubles their income tax bill, or more, while adding only 4 percent to Social Security revenues.

The Matrix of Middle Income Tax Misery

This table shows the effective tax rate retired couples pay on additional withdrawals from their retirement accounts. The calculations are done in increments of $8,000 to demonstrate the tax rates retirees experience if their income from Social Security and other sources ranges between $48,000 and $96,000.  For example, the tax rate on increases in other income from $24,000 to $32,000 if benefits are $24,000 is 15.35 percent. But if your benefits are $32,000 and your other income increases from $32,000 to $40,000, the tax rate is 28.25 percent.

Social Security Benefits $24,000 $32,000 $40,000 $48,000
$24,000
FIT with SS Taxed $333 $1,561 $3,676 $5,936
Tax rate on greater other income > 15.35% 26.44% 28.25% NA
$32,000
FIT with SS Taxed $533 $1,935 $4,195 $6,455
Tax rate on increasing other income > 17.53% 28.25% 28.25% NA
$40,000
FIT with SS Taxed $733 $2,454 $4,714 $6,974
Tax rate on increasing other income> 21.51% 28.25% 28.25% NA
$48,000
FIT with SS Taxed $1,092 $2,973 $5,233 $7,493
Tax rate on increasing other income > 23.51% 28.25% 28.25% NA