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What you need to know about how Social Security is taxed

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Editor’s note: This article first appeared on FedSmith.com. Click here for the original post.

Very little in the U.S. tax code draws the ire of taxpayers and creates confusion like the taxation of Social Security benefits. It is a toxic mix of complexity and unfairness that is assured to infuriate seniors.

How does the tax work? Current law uses your income to determine the amount of your Social Security benefits, which are taxable.  Once your income rises above a threshold, every dollar of income that you earn exposes more benefits from Social Security to taxation (up to 85 percent of your benefits). This means that $100 of income can create a tax liability based on as much as $185 of additional income. 

There are five things to know about these taxes. 

  • The rules create marginal taxes rates that are among the highest in the entire tax code. 
  • They have the greatest impact on people who have earnings outside of Social Security of $15,000-$40,000.
  • The people hit hardest by these rules are middle class people who saved for retirement with tax-deferred accounts.
  • There are socio and economic reasons that these taxes are reaching an ever-widening audience of retirees.
  • The trend will get worse rather than better

It may make seniors feel better knowing that the tax is really a means-tested clawback of benefits from retirees with substantial outside means. Tax revenue goes to the general fund. The revenue collected under these rules is returned to Social Security and Medicare, where it serves to prolong the ability of these programs to pay scheduled benefits.

How this revenue is used is very important. Lawmakers have fewer options on changing the rules when the money is dedicated to these programs.  Any adjustments to existing law — in, say, the threshold — requires that Congress would have to replace the lost revenue from another source. 

This distinction is entirely lost on seniors as they find out what ‘substantial outside income’ means to the IRS. The thresholds involved generally select someone who collects between $15,000 and $35,000 in income outside of Social Security. This group includes many people who saved in tax-deferred retirement accounts because these tools push past wages into your current income. Ironically enough, many of these people who used these accounts to avoid taxes will end up paying marginal tax rates that can approach 50 percent.

     

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Here is a practical example. My father sold his house for $300,000, which sum was subsequently invested at roughly 5 percent. His tax bill was small while he lived in his house. The $15,000 of interest earned was taxed at 15 percent. Unfortunately the additional interest income exposed an additional $9,750 of his Social Security benefits to taxes at 25 percent. In conjunction, his additional $15,000 of income created an incremental tax liability of $4,963, or 31 percent. That is a lot of money for someone who hadn’t paid $4,000 in income taxes since he retired.

The change in his income also affected his eligibility for deductions and credits. The formula for medical deductions on the schedule A, for example, lowers the amount of your deduction as your income rises. Under today’s tax code the reduction is 10 percent (for people born after 1949), or $2,475 in the case above. That translates into an increase of $600 in tax bill. Someone today in my father’s situation would pay roughly $5,300 in additional taxes on the incremental income of $15,000.

Understand that these rules will affect a larger audience over time because of inflation. The threshold which triggers the tax dates back to 1983, when $25,000 had the equivalent buying power of roughly $59,800 in 2014. Separately, Americans have increased their reliance upon tax-deferred investments like 401(k)s which push past wages through a retiree’s current income.  Bottom line, more people will pay the tax over time. 

IRS data confirms this trend. The number of returns with taxable Social Security benefits has more than tripled since 1990. In 2012, roughly 26 million income tax returns contained Social Security benefits. Of those, nearly 18 million returns contained taxable benefits, exposing more than 220 billion dollars of benefits to taxes and generating roughly 45 billion in revenue, which was returned to Social Security and Medicare.

To understand the anger, you have to strip away the side issues. People like my dad could not care less that you are taxing different revenue streams.  He does not care where the money goes. What he knows is that his income went up $1,000 and his tax bill went up $471. He knows that on Mitt Romney’s worst day he pays 39.6 percent plus the 3.8 percent net investment tax on his income.

The future of these rules is predicted to get worse. The Congressional Budget office projects that “income taxes paid on Social Security benefits will rise from 6½ percent of those benefits in 2014 to more than 8 percent by 2024 and more than 9 percent by 2039.” Furthermore, it reports that Congress is considering expanding these rules to all Social Security benefits making them even more onerous on the middle class.

It is no wonder that seniors fume. The government applies a means test that focuses the highest tax rates in the entire system on middle class income. These rules draw on savers who have demonstrated a distaste for taxes. These laws turn a system which was intended to alleviate poverty in the elderly into a system which fosters it.  It is a wonder why everyone isn’t fuming.