David Fromme is a former IRS Operations Research Analyst.
Hidden Taxes? This table sums it up.
|General Tax Rates||Rates for Social Security|
The up front tax bulge is a result of the manner Social Security Income is entered into taxable income, going from zero taxable up to 85% taxable. Many would argue that there is no such thing as the tax rate bulge – it is just how taxable SS Income enters into the equation. No! When you add $1,000 to gross income and taxes go up by $280 instead of $150, the marginal rate is 28% not 15% regardless of how it was calculated The discovery of this bulge led to further research yielding some surprising results including the following.
For the recipients
- Your taxes go up even if you withdraw money from an IRA or sell stocks to pay funeral, medical, or other emergency expenses.
- You can end up paying over $4,000 in taxes on SS Income that has already been taxed (50% was not previously taxed, 35% was).
- Getting married can create as much as a 500% increase in taxable SS Income.
- You can decrease your taxes over two years if you CRAM optional income into one year (when you hit the 85% limit on taxable SS Income) and take no optional income in the next year.
- If a recipient continues as a self employed person (not uncommon in the early years of retirement) taxes can exceed 60% (federal, state and self employment taxes) on part of their income.
- Retirement strategies need to have this factor in mind (e.g. paying off a mortgage can be far more valuable than stock dividends). Most financial advisors don’t take taxes on SS Income into consideration. These include many of the following:
- early retirement
- money planning
- investment plans
- retirement strategies
- emergency withdrawals for medical or other family needs
- the benefits of a Roth IRA
- the value of long term care insurance
- paying off your mortgage
- turning 70 and minimal IRA withdrawals are increased
- even getting married or divorced (I had to slip that one in)
- The value of having cash savings to avoid having to take withdrawals from taxable income
For the Federal Government
- Decreasing SS Income can increase the shortfall in the General Fund.
- Similarly, the extra 35% of taxable SS income is a de facto decrease in a recipient’s SS Income and what’s more the taxes go into the General Fund and not the Social Security Trust Fund.
- Increasing early retirement ages can increase the shortfall in the General Fund.
- Decreasing Medicare payments can yield a decrease of money going into the General Fund (remember medical expenses can be deducted).
The following case will provide you with a point of reference it is based on two couples with $80,000 in gross income. For one couple SS Income is $10,000 less and is offset by a $10,000 increase in other income.
|With $40,000 in Social Security and $40,000 in other income, the results were;|
|Income after SS Exclusion||Taxable SS Income||Final Tax|
|With $30,000 in Social Security and $50,000 in other income, the results were;|
|Income after SS Exclusion||Taxable SS Income||Final Tax|
Federal taxes are almost doubled. There is $4,200 increase in taxable Social Security Income even though total SS Income is lower by $10,000. Imagine if the lessened SS Income was the result of legislation. SS Income is lowered, taxes go up and earnings on other income could be decreased. This compounding could imperil America’s economy if it leads the growing number of seniors to reduce their spending to compensate for the reduced income. Less spending leads to fewer jobs and lessened FICA payments.
If the difference was the result of the couple’s decision to retire early, then the extra tax would diminish if the early retirement age was increased.
The national implications are especially important in view of concerns about the “Social Security shortfall” and emerging legislative proposals. But there is a series of interactions between Social Security payments, federal taxes and consumption that must be brought into play before any actions are taken by Congress. This does not appear to be the case. One example that is not considered is the continued inclusion of the 35% of SS Income in taxable income and introducing reductions in SS Income would be an extreme injustice.
Taken individually results may lead to different conclusions than when tax and SS Income are examined together. For example, raising the early retirement age is something that may intuitively be a good idea. But, with the 7% a year reduction in payments before full retirement age, it can actually raise individuals Social Security Income over the long term and decrease federal tax revenues.
Congress needs to consider all factors before jumping from the proverbial frying pan into the fire. Once all of the irregularities are worked out then action can proceed.
What should be done? High on the priority list are the following.
The de facto high rates for the middle class and the double taxation need to be rectified before Congress addresses other changes. Two critical actions are:
- Decide whether Social Security Income is to be:
- Taxable above 50% and abandon any other reductions in Social Security Income. If it is taxable, stretch out the inclusion in taxable income so it is not concentrated on a narrow band of taxpayers or,
- Taxable only up to 50% and Social Security Income may be subject to a reduction.
- Assure that the definition of “other income” is not distorted by actions such as extraordinary IRA withdrawals or stock sales to provide for expenses like medical, funerals or senior care.
- Conduct the studies that will provide a reliable base for making decisions.
So that I don’t leave with the impression that no change should be made, consider scaling COLA to other income. Barring run away inflation it would not lead to other distortions.
If the present structure is retained how does this do anything to rectify the “short fall”? It comes back to the “double taxation” money that currently goes into the general fund. Reduced payments are intended to enhance the Trust Fund. Returning the extra tax to the Trust Fund accomplishes the same thing (though not to the same degree). This change would not help the Federal deficit but it would reduce the Social Security shortfall.
* All calculations and other supporting documentation can be found on line at sites.google.com/site/ssincometaxandchange/. Also included are many other issues that have not been addressed in this article.