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.
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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.