Social Security benefits are taxable and can have the surprise effect of nearly doubling your marginal tax rate — the amount of tax you pay on receiving an extra dollar of income. How much of your Social Security benefits will be taxed depends on your “provisional income.”
Provisional income is adjusted gross income plus one-half of your Social Security benefits plus any tax-exempt interest you receive (such as from municipal bonds). When provisional income is…
Up to $32,000 on a joint return or $25,000 on a single return, no Social Security benefits are taxed.
More than $32,000 and up to $44,000 on a joint return, or more than $25,000 and up to $34,000 on a single return, each additional dollar of provisional income causes another 50 cents of Social Security benefits to be taxed until 50% of all benefits are taxed. So, receiving an extra $1 of income can cause you to owe tax on $1.50 of income.
More than $44,000 on a joint return or $34,000 on a single return, each additional dollar of provisional income causes another 85 cents of Social Security benefits to be taxed until 85% of all benefits are taxed. So, receiving an extra $1 of income causes you to owe tax on $1.85 of income.
Example: You file a single tax return, have taxable income of $34,000 from a pension and IRA accounts, and receive Social Security benefits.
Normally, $34,000 of taxable income would place you in the 25% tax bracket. But in this income range, increasing income by $1,000 — perhaps by taking $1,000 from a traditional IRA to meet a financial need — increases the amount of your Social Security benefits that are taxable by $850. So, you owe 25% tax on $1,850, causing $462.50 of tax to be due. This $462.50 of extra tax resulting from $1,000 of additional income is a 46.25% marginal tax rate.
What to do: Check to see if such a “boosted” tax rate will apply to your situation in 2008. Use tax software to run the numbers, or have a tax adviser do it for you.
If it will, be sure to pay enough income tax through estimated or withheld taxes to avoid underpayment penalties. Also…
If you’re about to retire, consider delaying first taking Social Security benefits until age 70 (at which point your benefits won’t be increased) to avoid this “boosted” tax rate during the years you’re not taking the benefit. When you delay taking benefits, you’ll receive correspondingly increased benefits later.
Make investments that don’t increase current provisional income, such as appreciating investments that will eventually receive favorable capital gain rates… life insurance products… tax-efficient growth mutual funds.
Take tax-free distributions from Roth IRAs instead of taxable distributions from traditional IRAs while in the “boosted tax rate” zone.