The reader was upset. He didn’t know it yet, but the “tax torpedo” had just hit his retirement. That’s the name I gave the taxation of Social Security benefits back in 2003. His note asked if there was some mistake in his income tax calculations. They didn’t make sense. If he took an extra $1,000 from his IRA account it was taxed more than he expected. But if he took another $20,000, the additional tax wasn’t so painful. No matter what, his tax bill was higher--- a lot higher--- than he expected.
How could that be? Easy. Welcome to the New America. This is the America that practices taxation without representation by building tax torpedoes into your future.
Here’s the story. In the early 1980s the Social Security system was running short on cash. A commission was created to study the problem and suggest solutions. Alan Greenspan, later to become head of our Federal Reserve Bank, was in charge. The commission recommended increasing the retirement age over a long period of time. It also suggested increasing the Social Security portion of the employment tax. The idea was to build a large trust fund. It would cover the baby boomers’ retirement.
The commission also recommended that Social Security benefits be taxed. Few retirees were affected by the tax in 1983 when the legislation was passed. The formula is one of the few items in the entire tax code that is not indexed to inflation. Result: few paid the tax then, but it hits many retirees today, with more expected in the future.
If you’re thinking, “Oh, that won’t affect me, I’m not rich” prepare for a shock. There is a good chance you’re rich enough. You can test this for yourself by using an online calculator on the SmartAsset website. A personal finance start-up, SmartAsset offers an array of calculators to help with financial decisions. Their income tax calculator handles the complexity of Social Security benefit taxation.
So, let’s see just how little income John and Jane Average need from savings to trigger the taxation of Social Security benefits. According to the April Social Security benefits report, the average retirement benefit is $1,346.72 a month. This means two average workers who are married would have combined benefits of $32,321 a year--- all tax free. They can take another $19,000 from their retirement accounts and still pay nothing in taxes. They wouldn’t pay any income taxes if Social Security benefits were counted, either.
Then, as total income exceeds $51,321 the first tax liability appears, $138. There would be no tax if Social Security benefits were not part of the calculation.
We could call this small beer. It’s a tiny tax bill. But consider the income: $52,321. Does that fit your notion of Fat Cat?
But it gets worse.
On the next $12,000 of additional income the couple pays $150 on each $1,000, a 15 percent tax rate.
After their other income exceeds $32,000, their tax rate jumps to 27.7 percent.
But let’s consider the Big Picture. How much do retiree tax bills increase when benefits are taxed? Try double.
If their other income is $33,000 (a total income of $65,321), taxation of benefits increases their bill from $1,230 to $2,475. That’s a double.
The story is less dismal for single taxpayers. A retiree with benefits of $16,161 a year can have an additional income of nearly $17,000 a year before there is a tax difference over not having benefits subject to taxation. At $20,000 in other income he or she will pay $1,215 in taxes with taxation of benefits compared to $984 if benefits weren’t taxed. With other income of $30,000 a year the tax bill will be $3,679 compared to $2,484, a difference of $1,195--- almost 50 percent more.
But note the highest total income being discussed, $46,161 for the single person and $65,321 for the couple. That’s definitely middle-income territory.
So I have a suggestion for our friends in Congress. They have been proclaiming their desire to “help the middle class.” They can show some good faith. They can start helping some of the middle class by repealing the taxation of Social Security benefits.