I was always working under the assumption that once we claim Social Security, 85% of our benefits will be counted as ordinary income on our federal tax return. That may also be a good assumption for a lot of retirees, especially if their overall income in retirement – pensions, capital gains, dividends, distributions from retirement accounts, Social Security, etc. – is high enough. Then, indeed, exactly 85% of your benefits will be taxed. This 85% figure is also the absolute maximum you’ll ever have to include in your federal taxable income. So, as a conservative estimate, it’s fine to use this 85% figure for our retirement cash flow and tax planning.

But in practice, the calculation is a lot more complicated. In fact, that share is calculated through a pretty convoluted formula that takes into account not just your Social Security benefits but also other income, even some ostensibly tax-free income like Municipal bond interest. In the chart below, the x-axis is for the annual Social Security benefits for a married couple filing a joint return (0-$80k), and each line corresponds to a level of all the other income (e.g., pensions, annuities, interest, capital gains, dividends, etc.) also going from $0 to $80,000 in $1,000 steps, so there are exactly 81 lines going from blue via yellow to red. When I plotted this function it looks like the folks at the IRS created a piece of art; that portion in the upper left looks almost like a Bifurcation diagram or Mandelbrot fractal!

In any case, for retirement planning, doing a more thorough analysis of our tax on Social Security rather than using the lazy rough estimates has at least four advantages:

1. The 85% estimate is likely way too conservative so you may over-prepare for retirement and over-accumulate assets. Why not enjoy your money now? Case in point, the Becky and Stephen case study last week; I was way too cautious with the tax assumptions in retirement and underestimated the sustainable, historical fail-safe retirement budget by about $2,500 per year!
2. The exact calculation of taxes on Social Security benefits has implications on your Roth conversion strategy: There’s no need to be aggressive with your Roth conversions if only a tiny fraction of Social Security is taxable and you have not much other income to fill up your federal Standard Deduction!
3. But for others, the convoluted formula also has a different, not-so-nice side effect. For some retirees, 401k or Traditional IRA distributions might be taxed at a higher rate than you might think. It’s called the retirement “Tax Torpedo,” more details on that below. So, if you don’t do enough Roth conversions and then later distribute money from a 401k you might face a higher tax burden than expected!
4. Even some of the ostensibly tax-free income (municipal bond interest or dividends/long-term capital gains in the first two federal tax brackets) may not be so tax-free after all. Because that income is included in the Social Security tax computation, you might face backdoor taxation of seemingly tax-free income. How sneaky!!! It might be optimal to do some tax gain harvesting prior to claiming Social Security!

So, in any case, I will go through some detailed calculations here today, and also link to an easy-to-use Google Sheet I created for you if you want to calculate your own retirement tax estimates. Let’s take a look…

Continue reading “Taxation of Social Security: The Tax Torpedo & Roth Conversion Tightrope” →