For most people, federal income taxes are straightforward during their working years because income is primarily from a paycheck. However, in retirement it can become much more complicated because income may come from multiple sources with different tax characteristics. Even Social Security benefits might be taxed, and the consequences can be complicated.
A key component of income in retirement is Social Security. A calculation based on overall income dictates how much of the Social Security benefit is taxable. That calculated income (sometimes called “provisional” or “combined” income) is essentially half of the Social Security benefit plus other gross income and any tax-exempt interest. If provisional income is $25,000 to $34,000 for single filers (or $32,000 to $44,000 for joint filers), then up to 50% of benefits are taxable. If provisional income is more than $34,000 ($44,000 for joint filers), then up to 85% of benefits are taxable.
This can create a unique situation to avoid: what researchers dub the “tax torpedo.” Clients are hit by this torpedo if they pay a high marginal tax rate because additional income causes more Social Security to become taxable. The marginal rate then decreases at higher income levels, which may not be something you’d expect in our progressive tax system.
The first step is being aware that this may be an issue. It may not be obvious, even looking at a tax return or software. One common trigger is required minimum distributions (RMDs), clients have no choice but to receive taxable income. People in the 10%, 12%, and 22% federal tax brackets could be affected, especially if they paid the maximum Social Security payroll tax in some of their working years. While “torpedo” sounds bad, a 22.2% marginal rate isn’t exactly disastrous. With that in mind, you might focus on situations resulting in the 40.7% marginal rate.
To read the rest of the Kiplinger article, including examples and ways to plan for (and avoid) the torpedo, click here.